Alphabet: Two Big Drivers Of Future Returns, This Stock Is Cheap

Summary

• Q2 2021 saw Alphabet deliver impressive performance, both on the top line as well as on its free cash flow line.
• YouTube and Google Cloud are even more attractive than they appear at first.
• Alphabet is still now, one of the best mega stocks to consider buying.
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Investment Thesis

Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG) reported top line growth of 62% y/y. Yet, beyond this headline figure, there's a lot worthwhile unpicking. For instance, YouTube grew 84% y/y and now makes up 11% of Alphabet's total revenues.

Another compelling opportunity is Google Cloud that was up 53% y/y. Although Google Cloud is operating at close to breakeven, keep in mind that Alphabet's main issue isn't a lack of profits. Indeed Google Cloud is now taking market share and growing faster than some of its big peers.

Altogether, I estimate that Alphabet trades for approximately 22x forward free cash flow.

In sum, Alphabet's stock is still reasonably priced and worthwhile considering.

Revenue Growth Rates Are Still Impressive

Source: author's calculations

As expected, Alphabet's Q2 2021 results shone strongly, with its revenues increasing by 62% y/y.

Given the recent results and commentary of many advertising companies in the sector, these results were hardly shocking.

However, despite the lack of positive surprises together with its Q2 results, there's still a lot worthwhile discussing.

Two Drivers Of Its Near-Term Prospects

When investors think about Alphabet, their minds immediately go to Google. However, at the back of their minds, while they may be aware of YouTube, as well as possibly Google Cloud Platform, I'm not convinced that investors are paying sufficient attention to these two operations. So here, I wish to unpick these opportunities.

For context, not only does YouTube now account for more than 11% of total revenue but YouTube is growing at a very fast clip. To illustrate, YouTube was up 84% y/y during Q2.

Accordingly, while acknowledging the easy comps with last year's quarter, as the whole advertising was in a slump last year, YouTube still put up a commendable performance during Q2 2021.

Taking a step back and keeping in mind Netflix's (NFLX) recent results and comments, Netflix declares that there's still a lot of room to go for households to ''cord-cut''.

Hence, along these lines, Alphabet's Chief Business Officer Philipp Schindler asserted during Alphabet's earnings call that advertisers are finding that YouTube reaches a very different audience from advertising on TV media. And that for brands, looking to reach different demographics away from linear TV, YouTube is a very attractive platform, backed with strong analytics and high ROI.

Here's what Schindler highlighted,

Nielsen found that US advertisers who shifted just 20% of spend from TV to YouTube generated a 25% increase to the total campaign reach within their target audience while lowering their cost per reach point by almost 20%.

Thus, not only is YouTube offering a lower cost per impression of 20%, but as you can see, it also drove increased reach per campaign.

Consequently, not only is YouTube well positioned with strong tailwinds but it is a very attractive platform for brands to increase mind share amongst consumers. To this end, brand advertising was the strongest driver of YouTube's revenue during Q2 2021.

Moving on, the other segment that's worthwhile discussing is Google Cloud. Google Cloud revenues were up 53% y/y and it is now responsible for more than 7% of Alphabet's total revenues.

What's more, when I remember that two years ago Google Cloud was the newest kid on the block with its cloud business and that so many investors were totally unwilling to consider Alphabet as a reasonable contender in the cloud wars, with Amazon's (AMZN) AWS and Microsoft's (MSFT) Azure being the only two meaningful players to dominate this space in the West, very few investors were willing to give Alphabet the benefit of the doubt.

Having said that, unlike its larger peers in the space, Google Cloud is still unprofitable. Even if the trajectory of its bottom profitability is making solid progress, its profitability pales in comparison with Amazon's AWS that in Q2 2021 reached 28% in operating profit.

However, given Alphabet's overall profitability, it makes a huge amount of sense that Google Cloud platform is now willing to compromise on its profitability as it seeks to gain market share of what is an incredibly lucrative space. So, let's now discuss Alphabet's profitability.

Free Cash Flow And Food For Thought

During Q2 2021, Alphabet's free cash flow reached $16 billion. Of that figure, Alphabet was able to return to shareholders approximately 80% of its total free cash flow.

That means that for every dollar of revenue that Alphabet made during the quarter, it ended up returning 13 cents to shareholders during the quarter.

In most instances, companies that end up with 13% operating margins are deemed by investors as very high-quality companies. In that light, what would readers say about a business that returns to shareholders 13% of its revenues?

Valuation - Still Cheaply Valued

Alphabet is valued at approximately 7x sales. This is not only a very cheap valuation for a company that's growing and is highly profitable, but it's cheap relative to potential alternatives facing investors.

If we assume that Alphabet continues to grow its free cash flow at 20% CAGR over the next twelve months, this implies that Alphabet's free cash flow may reach $80 billion.

What's more, given that Alphabet has such a rock-solid balance sheet with a large net cash position, this implies that a large portion of this free cash flow will end up being returned to shareholders via stock repurchases.

Moreover, given that its market cap is approximately $1.8 trillion, this puts the stock priced at approximately 22x forward free cash flow.

There's very little chance that anyone can argue that this tech giant is overpriced right now.

Indeed, many of Alphabet's peers outside of Alphabet's and Facebook's (FB) walled garden are clamoring for scraps left over by these two tech giants are getting priced at close to 20x forward sales.

In comparison, paying 22x forward free cash flow for Alphabet strikes me as particularly cheap.

The Bottom Line

Alphabet has been on a terrific run this year. Yet, when it boils down to it, despite the stellar performance, the stock is still cheaply valued at 22x forward free cash flow.

I argue that Alphabet's YouTube and Google Cloud businesses are two diverse opportunities that investors aren't paying sufficient attention to.

Having all that, I still prefer to invest my own capital into out-of-favor smaller cap stocks. Happy investing!

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.