In my recent Qualcomm (QCOM) article on Seeking Alpha with the title "Why The Success Story Just Begins," one of the Seeking Alpha members asked me to write more about technology stocks.
On the one hand, I decided to fulfill the wish of the aforementioned Seeking Alpha Member with this article about Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL). On the other hand - while Alphabet is not my (from an emotional point of view) favorite (technology) stock - I would like to demonstrate why it is a must-have stock for investors at the beginning of the next decade.
As there are a couple of articles in general and on Seeking Alpha justifying an investment in Alphabet, I would like to focus in this article only on what I consider to be the core arguments.
Before discussing the core arguments for an investment in Alphabet, let's take a look at the stock performance against the S&P 500 and Nasdaq 100 indices in 2019.
As the following chart illustrates, Alphabet shares slightly outperformed the S&P 500 (SPY) (28.48%) in 2019 with a year-to-date performance of 28.89%, whereas the shares underperformed the Nasdaq 100 technology index (QQQ) (37.22%) by a considerable amount.
(Alphabet's year-to-date stock performance vs. SPY and QQQ. Source: YCharts)
Even though I am not a fan (anymore) of comparisons between the performance of different stocks, in the present case it may be helpful to get an overview of the performance of the largest and most important US technology stocks. According to the chart below, only Amazon (AMZN) has delivered a "worse" performance than Alphabet with a year-to-date gain of 19.24 percent (see following chart).
(Alphabet's year-to-date stock performance in peer group comparison as of 24 December 2019. Source: YCharts)
Looking at the performance over the last three years, Alphabet even comes off worst in the peer group with a performance of "only" around 66 percent (see following chart).
(Alphabet's three-year stock performance in peer group comparison. Source: YCharts)
For the sake of completeness, it should be mentioned that Alphabet shares outperformed the S&P 500 Index with a performance of 66.65% over the three-year period, but underperformed the Nasdaq Index (see following chart).
(Alphabet's three-year stock performance vs. SPY and QQQ. Source: YCharts)
So, what are the reasons for investing in Alphabet despite a previous underperformance in peer group comparison?
What are the reasons that could change this development and cause Alphabet stock to outperform the benchmarks in the future?
Otherwise, it would make no sense to invest in Alphabet shares if a) the share underperforms the Technology Index while at the same time being exposed to a higher level of risk (due to a lack of diversification) and b) delivers a much higher level of volatility compared to the more broadly diversified indices (with regard to the higher volatility, see the following chart).
(Alphabet's 30-Day Rolling Volatility vs. SPY and QQQ. Source: YCharts)
In the following chapters, let's take a look to my core arguments which could justify an investment in Alphabet.
There is an important development, which, in my opinion, has been far too little noticed and rewarded by the market, probably due to Apple's (AAPL) impressive year-to-date performance and the market's focus on the trade disputes between the US and China.
As the Financial Times became the first to report in July 2019, corporate America had a new "Cash King". The title for the company with the largest cash holdings, held by Apple for a decade, had passed to Google’s parent, Alphabet, according to figures released in the quarterly earnings reports (by the way, there is another exciting development in connection with the FAANG stocks, which I would like to discuss in one of my upcoming articles - stay tuned).
This development is also impressive due to the fact that Alphabet has succeeded in becoming one of the world's highest revenue- and profit-generating companies in addition to its immense cash holdings within just 21 years of its existence.
Though it's worth mentioning that in the meantime, Alphabet has also been dethroned by Microsoft (MSFT) and Warren Buffett's Berkshire Hathaway (BRK.A, BRK.B), which, according to a CNBC report dated 7th November, 2019, had $136.6 billion and $128.8 billion in cash and short-term investments respectively (see following figure).
(Companies with the most cash on hand as of 7th November, 2019. Source: CNBC)
Based on 3Q 2019 earnings report, Alphabet had a total of $121 billion in cash. After deducting its long-term debt of $4 billion, the net cash position stands at $117 billion. The net cash holdings of $117 represent thirteen percent of the company's market cap (see red marks in the following figure).
(Alphabet's cash holdings and long-term debt as of 3Q 2019. Source: Alphabet Third-Quarter 2019 Results)
In addition to the operating performance, one factor stands out in particular which can have a significant impact on share performance, as can be seen especially from the example of Apple. Despite cutting the revenue guidance in January 2019, as a result of which Apple's market capitalization briefly fell behind that of Microsoft, Amazon and Alphabet, the company delivered an impressive outperformance, which can be attributed primarily to the immense share buyback program.
As one evidence to this thesis, the following figure illustrates Apple's buyback volume compared to Microsoft, Alphabet, Amazon and Facebook (FB) over the past twelve months. As a result, the company has spent more than $66 billion on share buybacks, which is a very impressive amount. This is more than three times the amount of money that Microsoft ($19.5 billion) and Alphabet ($14 billion) each have spent on share buybacks. Or, in other words, Apple has spent more money on share buybacks than Microsoft, Facebook, Amazon and Alphabet combined ($40 billion), as illustrated by the following figure.
(Comparison of stock buybacks from selected companies during the past twelve months. Source: YCharts)
While the size of the share buybacks ultimately speaks for Apple's financial strength, it also illustrates the importance of share buybacks in terms of shareholder value. As shown above, the company has outperformed its peer group by far with a year-to-date performance of 79.69% without really convincing from an operational point of view considering the guidance cut in early 2019 and decreasing revenues.
Consequently, appointed as the new Alphabet CEO and in consideration of the immense cash reserves, I expect Sundar Pichai using buybacks, among others, as a key instrument in order to attract new investors and push the stock to new heights in the coming year(s). After all, a strong share performance is primarily in his interest as the (newly appointed) CEO, which is also one of the key measures to evaluate the CEO's performance.
One step that could confirm this thesis is the fact that in July 2019, Alphabet management added $25 billion to its stock buyback program, taking total new repurchase authorizations to nearly $40 billion since the start of this year. Considering the fact that Alphabet spent $12 billion in the nine months ended 30th September, 2019, at least $28 billion will be left under the current buyback program.
Taking into account the market capitalization of $927 billion, this amount may not seem impressive, but it creates additional demand amounting to three percent of the current market capitalization, which could additionally reduce the stock's volatility.
Based on 3Q 2019 results, Alphabet spent $5.7 billion on stock repurchases in the past quarter, which stepped up repurchase levels by nearly 60% in comparison to 3Q 2018. Assuming that Alphabet keeps spending $5.7 billion each quarter for stock repurchases, the pending buyback program amounting to $28 billion should continue for at least five more quarters and potentially push the stock to new heights in 2020 (see red marking in the following figure).
(Alphabet's stock buybacks as of 3Q 2019. Source: Alphabet Third-Quarter 2019 Results)
Finally, it is worth mentioning in this context that Alphabet only hesitantly began to buy back shares in the fourth quarter of 2015 (maybe thanks to CFO Ruth Porat, a former Morgan Stanley executive who joined Alphabet in 2015), while its peers Apple and Microsoft are already more familiar with share buybacks and, for example, Apple has ramped up its share buyback program by more than 50%, or nearly $30 billion, compared with previous years (see following chart).
(Buyback history of Alphabet and peer group. Source: YCharts)
Consequently, I am quite optimistic that Alphabet will focus more on share buybacks as a form of increasing shareholder value, which management has already indicated by increasing the share buyback program in July 2019 by an additional $25 billion.
Let's now have a look on Alphabet's most recent earnings results before we dive deeper into the valuation of the stock.
Before discussing last quarter's results, I would like to insert an overview of Alphabet's revenue breakdown and segments. The illustration below was created by Visual Capitalist, which should help the reader get a better understanding of the components of Alphabet's different segments and revenue generation.
(Alphabet revenue breakdown as of March 2019. Source: Visual Capitalist)
As the figure above illustrates, Google's revenues are comprised of the following three core segments: a) Google Properties revenues: this includes revenues generated from Google Search engine and YouTube; b) Google Network Members' properties revenues: this includes revenues generated from Google Ads; c) Google's other revenues: this includes revenues generated from Google Cloud Platform and Google Play Store.
With a revenue contribution of over 70%, the "Google Properties" segment is the largest revenue contributor to Alphabet's revenues, up 19% year over year, followed by the Google Other segment with a revenue contribution of 16%, which surpassed the Google Network Members' properties segment (with a revenue contribution of 13%, up 7.5% year over year) in the last quarter, thanks to strong growth in the cloud business and Play Store, up 39% year over year. The "Other Bets" segment is currently an insignificant contributor to revenues, with sales of only $155 million.
With reference to the last quarter, Alphabet reported revenue of $40.5 billion on a consolidated basis, up 20% year over year, or 22% in constant currency. This easily surpassed analysts' consensus estimates, which were calling for revenue of $40.33 billion. It also accelerated from Alphabet's 19% growth in 2Q 2019. Main drivers for top line growth, according to CFO Ruth Porat, were ongoing strength in mobile search, YouTube and Cloud. The following chart presents the segment revenues compared to the year-ago quarter:
(Alphabet segment results in 3Q 2019. Source: Alphabet Third-Quarter 2019 Results)
While the top line growth exceeded analysts' estimates, the bottom line, on the other hand, was a source of investor disappointment. Although operating income rose from $8.6 billion to $9.2 billion, which corresponds to an increase of seven percent year over year, the operating margin in the same period fell from 26% to 23%.
Net income of $7.068 billion fell 23% year over year, generating earnings per share of $10.12, down about 23%, and falling far short of expectations of $12.28.
At the same time, the share count was reduced by around 6 million from 704 million to 698 million, thanks to the ongoing buyback program.
It is worth mentioning that according to Alphabet CFO Ruth Porat, profitability was negatively impacted by two large items. First, operating income was negatively impacted due to a $554 million charge related to a recent $1 billion tax settlement in France. Second, profits were affected by a $1.479 billion loss on equity investments (compared to a gain of $1.35 billion in the comparable year-ago quarter), which is a development difficult to predict due to Alphabet's stakes held in other companies such as Uber (UBER) and Lyft (LYFT).
With Alphabet having about 698 million shares outstanding, these two factors alone reduced the company's earnings per share by $2.91. Added back to the company's reported EPS of $10.12, that would have resulted in EPS of $13.03, easily surpassing analysts' consensus estimates (analysts' estimates were EPS of $12.46) but slightly lower compared to the year-ago quarter with an EPS of 13.06 (see following figure).
(Overview of Alphabet's 3Q 2019 results. Source: Alphabet Third-Quarter 2019 Results)
Free cash flow for the current quarter was $8.734 billion, an increase of approximately 10% over the same quarter last year (Q3 2018: $7.928 billion).
Continuing with profitability, on a consolidated basis, total cost of revenues was $17.3 billion, up 25% year on year. Other cost of revenues on a consolidated basis was $10.1 billion, jumping 35% year over year, primarily driven by Google-related expenses, said CFO Ruth Porat. She added that the biggest contributor last quarter was costs associated with the data centers and other operations, including depreciation, followed by content acquisition costs, primarily for YouTube and mostly for the company's advertising-supported content, but also for the newer subscription businesses, YouTube Premium and YouTube TV.
Operating expenses were $13.8 billion, up 27% year over year, with headcount growth being the largest driver of year-on-year growth for both R&D and sales and marketing, which is reflected in both compensation and facilities expenses.
The following figure illustrates the cost breakdown in the most recent quarter:
(Cost breakdown as of 3Q 2019. Source: Alphabet Third-Quarter 2019 Results)
With regard to future profitability and strategy, CFO Ruth Porat mentioned the following:
And as we said, since the IPO, we don't manage the business to maximize quarterly results and we'll always do the right thing for the long term. We're very focused on investing for the long term. And I tried to make it clear in opening comments that as a result, quarterly growth can vary and has varied. And I think to your question, our view is that quarterly growth around the rates you've seen since the beginning of the year, for us underscore the strength and the vibrancy actually in our business. And that's particularly true at our size, in the last 12 months we've generated over $150 billion in total revenues. That's about $25 billion of growth in the last year. And we are continuing to invest in long-term opportunities. But, I would make the point that we do keep a lens to the long-term.
Now, zooming out to a bigger picture and looking at the development over the last three years, the following picture arises. While Alphabet is characterized by a healthy top line growth averaging over 20% over the last three years, its earnings show a volatile picture (see following figure).
(Alphabet's annual income statement data and analyst estimates. Source: MarketScreener)
At the same time, free cash flows also show a volatile picture during the last three-year period (see following figure).
(Alphabet's FCF over the last three years and analyst estimates. Source: MarketScreener)
Nevertheless, the net income and EPS average growth during the past five years was well above 18%. The net income and EPS average growth during the past three years was even higher at about 24% (see green and red marks in the following figure).
(Alphabet's average net income and EPS average growth during the past three and five years. Source: Morningstar)
According to MarketScreener, the analysts' consensus estimates predict an average EPS growth of about 15% for the coming three years and an average FCF growth of more than 25% for 2020 and more than 20% for 2021.
I have prepared two valuation models for the fair value calculation. In the first valuation model, the free cash flows for the next ten years are discounted at 6% and the result of the tenth year is multiplied by 16.26. The present value of the sum of the FCF of the first ten years (here: $346,34 billion) and the value of the FCF of the tenth year (here: $661,54 billion) are then added together and further added with the net cash position (here: cash on hand amounting to $121,177 billion minus debt and liabilities amounting to $4,082 billion). On this basis, the enterprise value is determined. After dividing the enterprise value by the number of shares, the fair value per share is determined.
In order to choose a conservative approach, I have chosen a growth rate of 10% per year in terms of the free cash flow, since I assume ongoing investments in headcount, data centers and small-scale acquisitions such as Fitbit (NYSE: FIT) in order to strengthen the consumer devices and smart home business. These investments could negatively impact free cash flow in the foreseeable future, according to my assumption.
Furthermore, I have chosen a multiple of 16.26 for the last FCF, which represents the lowest Price/Cash Flow multiple during the last five years and is lower than the 5-year average of 18.08, according to Morningstar (see red marks in the following figure).
(Alphabet's valuation as of 24th December, 2019. Source: Morningstar)
In the second valuation model, earnings per share for the next five years are also discounted at 6% and a terminal value is calculated. Finally, the fair value is determined on the basis of earnings per share for the next five years and the terminal value. In order to choose a conservative approach, I have chosen a P/E multiple of 28.21, which represents the lowest P/E multiple of Alphabet during the last five years. The average P/E ratio of the last five years was 34.07, according to Morningstar (see green marks in the figure above).
Based on the first valuation method, the fair value is $1,611,71, which corresponds to an undervaluation of the stock of 20% (see figure below).
(Fair value calculation - Method I. Source: Author's calculation)
Based on the second valuation method, the fair value is $1,728.12, which corresponds to an undervaluation of the stock of 29% (see figure below).
(Fair value calculation - Method II. Source: Author's calculation)
The discount rate of 6% appears low at first glance. Given the fact that Alphabet has a dominant market presence, a net cash position of $117 billion, a solid and growing free cash flow and the extremely low Fed Funds rate of 1.50-1.75%, I consider a discount rate of 6% to be appropriate.
Although I had mentioned that I am not a fan (anymore) of comparing the performance and valuations of different stocks, there is one chart that I do not want to withhold from the reader in this context.
As can be seen in the chart below, Alphabet and Apple have almost the same forward enterprise value-to-revenues multiple, while Apple's revenues are almost stagnant and Alphabet is growing at around 20%. At the same time, Alphabet has currently surpassed Apple in terms of net cash position.
On the contrary, Microsoft and Facebook have a more than 50% higher forward enterprise value to revenues multiple, even though Microsoft grew 13.7% and Facebook 29% in the last quarter, but with revenues of $17.6 billion, Facebook has not even half the revenue base of Alphabet. It is also noteworthy that Alphabet currently generates $25 billion more revenue than Microsoft on a trailing twelve months basis. In this respect, this valuation multiple could be a further indication of the need for the Alphabet share to catch up in terms of valuation.
(Alphabet's forward EV-to-Revenues in peer group comparison. Source: YCharts)
While there is hardly a way around Alphabet on the World Wide Web, there are also some potential weaknesses and risks facing the company, the impact of which cannot currently be quantified in figures.
First, noteworthy are antitrust probes, digital tax plans and investigations in the context of data collection and data security by public authorities all around the globe. While the exact outcome or extent of these investigations cannot be precisely quantified, the fines that Alphabet has had to afford so far remain minimal given the immense cash holdings. As already mentioned in the context of the quarterly results, the company agreed to pay around $1 billion to French authorities to settle a fiscal fraud probe that began four years ago.
Second, cloud computing is one of the most promising drivers of future growth and - as already outlined above - is one of Alphabet's greatest hopes. Although Alphabet increased its share of the global cloud computing volume from 5.6% to 6.9% last year, according to a study by Canalys, the company still lags miles behind Amazon and Microsoft. At the same time, other companies are also increasing their investments in cloud computing (e.g. Alibaba (BABA), Tencent (OTCPK:TCEHY, OTCPK:TCTZF), SAP), so competition should become even tougher in the future, even though the total addressable market currently seems to be huge (see following figure).
(Cloud computing market shares as of October 2019. Source: Canalys)
Third, there are frequent articles about Amazon, Facebook and other companies eating into Alphabet's search ad revenues share. According to a current report by eMarketer published by CNBC in October 2019, the U.S. search ad market is expected to grow nearly 18% in 2019 to reach $55.17 billion. According to eMarketer, Google currently holds a 73.1% market share, equaling $40.3 billion. Meanwhile, Amazon is estimated to grow nearly 30% to reach $7.09 billion in 2019, reaching 12.9% of market share. Amazon’s share is estimated to grow to 15.9% by 2021, with Google’s estimated to drop to 70.5% of the market. Amazon last year surpassed Microsoft to become the second-biggest ad platform for search in the US, according to eMarketer (see following figure).
(US companies ranked by search ad revenue share 2019. Source: CNBC).
Fourth, despite all its efforts, Alphabet still ranks behind its competitors in terms of wearables, so from an organic point of view, the company does not even rank among the top 10 vendors. In order to strengthen the consumer devices segment, the acquisition of Fitbit, one of the pioneers in the area of wearables and wrist-worn devices, was announced this year in a deal that values Fitbit at a fully diluted equity value of approximately $2.1 billion. As the figure below illustrates, this acquisition makes Alphabet the fourth-largest vendor of wearables and wrist-worn devices.
(Top five wearables companies. Source: IDC)
According to IDC, shipments of wristwear, including watches and wristbands, grew 31.6% year over year and continue to dominate the wearables landscape, accounting for 63.2% of all wearables shipped during the first quarter of 2019. However, ear-worn devices experienced the fastest growth (135.1% year over year) and accounted for 34.6% of all wearables shipped.
Fifth, in terms of smart speaker and smart home products, Canalys reports that the global smart speaker market grew 55.4% year over year in 2Q 2019, reaching 26.1 million units shipped during the quarter. Amazon maintained its position as market leader, with Baidu (BIDU) surging into second place and surpassing Google. Amazon’s Echo continues to be the most popular smart speaker in the world with a 61.1% annual growth rate from Q2 2018 to 2019. Google was the only one of the top five smart speaker makers to lose market share over the past year, according to Canalys (see following figure).
(Worldwide smart speaker shipments and annual growth as of 2Q 2019. Source: Canalys)
"Know what you own and why you own it."
- Peter Lynch
In this article, I aimed to explain why Alphabet is a must-have stock for investors at the beginning of the next decade. At the same time, I tried to focus on what I consider to be the core arguments.
First, I highlighted Alphabet's net cash position, which now corresponds to 13% of market capitalization, and the company has even surpassed Apple as the former cash king after holding the title for more than a decade. As management increased the share buyback program by an additional $25 billion in July, and with no positive surprises expected in the short term from the business development side, I expect that cash will increasingly be used for share buybacks and the main driver to boost shareholder value. After all, a successful share price performance will also be in the interest of the newly appointed CEO Sundar Pichai, whose performance will ultimately be measured by the stock performance.
Second, I presented two valuation models for fair value calculation based on FCF and EPS. Both fair value calculation models resulted in an undervaluation of the share of 20% and 29% respectively. In this context, I demonstrated that Alphabet has a solid business model with a dominant market position and healthy top line growth, with bottom line growth suffering in the short term due to investments in the company's future growth. Furthermore, I highlighted several threats, weaknesses and risks Alphabet is faced with. This includes both regulatory risks and competition threats. Consequently, in order to adequately account for these risks and the volatile bottom line growth, I have chosen a conservative growth rate of 10% each for EPS and FCF.
Nevertheless, since management has already made it clear that the focus is on long-term success, as mentioned by CFO Ruth Porat during the most recent earnings call ("We're very focused on investing for the long term. And I tried to make it clear in opening comments that as a result, quarterly growth can vary and has varied."), I do not expect any major surprises in terms of FCF and EPS. On the one hand, as long as Alphabet does not conjure rabbits out of a hat, the stock price will probably be driven primarily by the company's share buyback program and the general sentiment of the market. On the other hand, the buyback program offers investors a margin of safety in the event of a market turmoil.
While I see currently no reason to overweight a particular stock for any particular reason (which, in my opinion, would ultimately fall under "timing the market," and stock price developments are difficult to predict, as we all know), I consider the Alphabet stock to be one of the must-have stocks ("time in the market") for investors for the reasons outlined above.
I have had the experience that investing is most successful when it is (unfortunately) boring, and I think Alphabet falls perfectly into this category.
Finally, in my opinion, it is essential for Alphabet to strengthen the consumer devices, smart wearables and smart home segments in order to better capitalize on the consumer market potential in future.
So, I wish you a Happy New Year and very much success with your (boring) investments!
PS: I intend to publish more about tech stocks in future. If you are interested in finding out my (from an emotional point of view) favorite technology stocks, just follow me on Seeking Alpha.
This article was written by
Disclosure: I am/we are long GOOG, GOOGL, FB, AMZN, MSFT, AAPL, BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.