Alphabet: It's A No-Brainer

Summary

• Alphabet is seemingly undergoing a late evolution from the former 'Techie Company' to a future 'Capitalist Company.'
• While the company was unable to exceed expectations in the last quarter, it seems to be a no-brainer given its increasing focus on monetization, profitability and growth under its new CEO.
• The tech giant disclosed further information on its revenue generation which underpins its ambitions to become a more transparent and shareholder-friendly company.
• Furthermore, the valuation seems still to be attractive combined with a rock solid fundamental situation as well as its remaining buyback program amounting to $21B.

1. Foreword

I started coverage of the Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) stock on Seeking Alpha for the first time with my article entitled "Alphabet: Why The New 'King Of Cash' Is A Must-Have Heading Into The Next Decade" dated December 27, 2019.

My decision was based among other things on the fact that a) with the appointment of the new CEO Sundar Pichai, Alphabet could focus more on shareholder value to drive share performance and b) Alphabet could use its excessive net cash position of $117 billion to do so by buying back shares.

Furthermore, I highlighted the (under)performance of the stock compared to the other "tech giants":

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 December 24, 2019. Source: YCharts)

If you have not yet read my previous article, I would strongly recommend you to do so.

In order to look now to the present and to the future, Alphabet presented its Q4 figures on Monday after-market. While the market reaction was mixed, my first thought was: "Alphabet is undergoing a late evolution from the former 'Techie Company' to a future 'Capitalist Company.'"

In the following I will explain why, by discussing the good and bad parts of the quarterly report.

(Google Search. Source: Pixabay)

In my previous article, I had described the individual business segments and their breakdown, so in the event of any ambiguities in further elaborations, I would like to refer to my previous article.

2. The evolution from the original 'Techie Company' to a future 'Capitalist Company'

While the company was able to exceed expectations for earnings per share, it failed to meet revenue expectations:

• Revenue increased year over year by 17%, or 20% in constant currency, to $46.08 billion in Q4 (consensus: $46.87 billion).
• Operating income increased by 13% to $9.27 billion, while operating margin decreased to 20% (consensus: $9.86 billion).
• Net income increased by 19% to $10.67 billion.
• Earnings per share increased by 20% to $15.35 over the same period, exceeding expectations by an impressive 22% (consensus: $12.54).
• Free cash flow grew by 42% to $8.4 billion year over year in Q4 (Q4 2018: $5.9 billion).
• In FY 2019, FCF grew by 36% totaling $30.97 billion (FY 2018: $22.82 billion).

The following figure provides an overview of Alphabet's quarterly results (see red marking):

(Alphabet's Q4 2019 results. Source: Alphabet)

Nevertheless, the biggest surprise with the appointment of CEO Sundar Pichai in the current quarterly report was the disclosure of revenues on a more granular basis to give greater insight into Alphabet's business.

In this context, revenues for Google Search & other and YouTube ads (formerly subsumed under "Google properties") as well as Google Cloud and Google other, which includes YouTube non-advertising revenues (formerly subsumed under "Google other revenues"), were disclosed.

The following figure provides an overview of Alphabet's expanded revenue disclosures for Q4 and the past three years:

(Overview of Alphabet's expanded revenue disclosures. Source: Alphabet)

Although the market seems to be underwhelmed by Alphabet's revenue growth, it is noteworthy that Alphabet is growing at double-digit rates in each segment. For example, Google Cloud revenues alone have more than doubled since 2017.

Google Cloud ended 2019 with revenues of $8.9 billion, up 53% year over year. It is striking that revenue growth in the cloud business has accelerated compared to the previous year. It grew by 53% in 2019 despite a larger revenue base compared to a revenue growth of 44% in 2018.

CEO Sundar Pichai mentioned during the earnings call that he is pleased with the momentum in the Cloud business and revealed that the number of deals over $50 million more than doubled, year over year.

Given the opportunity and the momentum, the company accelerated its investment in the go-to-market team and set a goal to triple the size of the sales force. The company also aims on building out the product road map and extending the global footprint of its infrastructure.

Pichai also highlighted the cross-selling potential in connection with larger companies by combining Google Cloud, Android Auto, Waymo as well as advertising with regard to, for example, automotive companies. Consequently, growth in the cloud sector could gain further momentum in future.

Beyond the cloud business, the CEO sees YouTube and YouTube TV subscriptions as two new growth areas for the future. Turning to YouTube, YouTube ad revenues have also almost doubled in the past two years. YouTube reached $15 billion in ads revenue in 2019 growing at 36% compared with 2018. Additionally, it now has over 20 million music and premium paid subscribers and over 2 million YouTube TV paid subscribers, ending 2019 at a $3 billion annual run rate in YouTube subscriptions and other non-advertising revenues. The company intends to build out YouTube subscription services, according to the CEO.

Nevertheless, Alphabet's largest revenue contributor remains Google Search with a 61% revenue share and a revenue run rate of $98 billion in 2019. This segment has grown by a healthy 15% in 2019, year over year.

However, I also find it disappointing that Alphabet failed to meet top-line expectations despite a strong holiday season and strong US consumer spending in contrast to its mega-cap peers. The company fell short of expectations in all areas in terms of top-line growth.

Especially in the North America region, growth slowed down both in percentage and absolute dollar terms. While growth in 2018 was 20% and more than $3 billion in the North America region, it has fallen to 16% and nearly $3 billion in 2019.

According to management, the U.S. year-on-year growth rate does reflect a decline in hardware revenues compared to what was a strong hardware revenue growth rate in Q4 2018. Maybe the hardware business could be boosted in the future through the takeover of Fitbit (FIT).

Turning to fundamentals and buybacks, Alphabet finished the year 2019 with a net cash position of $105 billion. CFO Ruth Porat highlighted that in Q4 the company repurchased $6.1 billion of shares, which was more than double the amount of repurchase in Q4 2018. She added that as of year-end, the company had $21 billion remaining in the program and will be focused on executing on the remaining authorization at a pace that is at least consistent with what we saw in the fourth quarter. This means for me that Alphabet will buy back its own shares worth at least $21 billion on the market this year.

To conclude, based on the CEO's and CFO's statements during the earnings call with analysts, I have the impression that the company will be increasingly trimmed on monetizing its various divisions (especially other bets), increasing its profitability (e.g., building out YouTube subscription services) and gaining market share (particularly with regard to Google Cloud).

3. Fair value calculation based on DCF and EPS indicates upside potential of at least 22%

Given the FY 2019 results, I have decided to update my fair value calculations. In this context, I have prepared two valuation models for the fair value calculation.

In the first valuation model, I will calculate the fair value on an EPS basis. In the second valuation basis, I will use a DCF-method.

If something should be hard to follow in connection with my elaborations or fair value calculation, I recommend my previous article for reference, because my approach is the same, but I used the current Q4 figures.

In the first valuation model, 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 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.

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.

Based on the first valuation method, the fair value is $1,756.97, which corresponds to an undervaluation of the stock of 22% (see figure below).

(Fair value calculation - Method I. Source: Author's calculation)

Based on the second valuation method, the fair value is $1,908.59, which corresponds to an undervaluation of the stock of 32% (see figure below).

(Fair value calculation - Method II. Source: Author's calculation)

Nevertheless, the current calculation does not include the impact of the outstanding buyback program amounting to $21 billion. The share buy-back program is very likely to provide a further boost to the share price.

4. Conclusion

As already mentioned in the introduction, with the replacement of co-founder Larry Page by Sundar Pichai as new CEO, Alphabet is currently undergoing a late evolution from the former 'Techie Company' to a future 'Capitalist Company,' which strives for greater efficiency, profitability and monetization.

Three developments underpin my assumption. First, the biggest surprise with the appointment of CEO Sundar Pichai in the current quarterly report was the further revenue disclosures to give greater insight into Alphabet's business. This is a clear sign for more transparency and self-confidence of the company. This transparency also underlines Alphabet's growth ambitions in each of its disclosed business areas.

Second, Alphabet's so-called 'Other bets,' such as Waymo, Verily and Fiber, are increasingly focused on their evolution as a business and on strategic partnerships. Waymo, for example, is working closely with OEMs and other businesses to build out ride-hailing and delivery business lines.

Third, the company focuses more on shareholder value and is executing an accelerated share buyback program of at least $21 billion in 2020. Taking into account Alphabet's net cash position of $105 billion and steady growing free cash flow, I believe, as I emphasized in my previous article, that this amount could be increased further in the course of the year.

Furthermore, I presented two valuation models for fair value calculation based on FCF and EPS. Both fair value calculations resulted in an undervaluation of the share of 22% and 32%, respectively.

Nevertheless, even if the share appears fundamentally undervalued, unexpected events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.

In the context of headwinds, antitrust probes, digital tax plans and investigations in the context of data collection and data security by public authorities all around the globe could be mentioned. Depending on the results of these investigations, the share price could come under pressure, which could lead to buying opportunities based on the outcome.

PS: I intend to publish more about tech stocks in future. If you are interested in finding out my favorite technology stocks, just follow me on Seeking Alpha, my personal blog or on TipRanks.

Disclosure: I am/we are long GOOGL, GOOG. 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.