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Investment Thesis
Under the current risk-off environment, Mr. Market's relentless focus on commodities, metals, energy, and other materials stocks has created a unique entry point for the technology conglomerate Alphabet Inc. (NASDAQ:GOOG). The analysis explores the company's growth prospects and concludes that the stock is a compelling growth at a reasonable price (GARP) investment, based on the current price. Thus, GOOG earns a strong buy rating given the anticipated bear market, and a prudent strategy would be to add positions on the market's drops.
GOOG's Growth Prospects
Google has benefitted enormously from the rise in digital adoption over the past decade, and the pandemic further forced momentum into the transition as the advantages of digitalization became even more evident to people.
Google Services
Google Search & other revenues increased by $44.9 billion in 2021, recording an impressive growth of 43% YoY. The overall growth was driven by interrelated factors, including increased user adoption amid COVID-19, higher advertising spending, and Google’s ad infrastructure improvements. In addition, the company's ecosystem with a broad range of core products (i.e., Chrome, Gmail, Gdrive, Maps, and other apps) keeps growing and provides a superior value proposition for advertisers.
10-K Form (abc.xyz/investor)
Additionally, the eCommerce boom has been a key factor behind the company's revenue growth. Although online sales have picked up after the COVID-19 pandemic, eCommerce sales in 2021 accounted for 13.2% of the total retail sales in the US. With digitalization on the rise, there is still plenty of room for growth in eCommerce, boosting Google's core search business.
Undoubtedly, Google’s dominant position in global search advertising has benefitted from the remarkable global shift to eCommerce from brick-and-mortar stores. Although eCommerce spending is expected to normalize after the post-Covid boom, it is still expected to grow faster than overall retail. This year, worldwide sales will exceed $5 trillion for the first time in 2022, accounting for more than a fifth of overall retail sales. As retailers increasingly shift toward digital customer acquisition, Google stands to be an outsized winner, given its position as one of the key marketplaces sitting between merchants and potential consumers.
eMarketer Forecast (emarketer.com)
Even though digital adoption spiked in 2020, digital advertising still lagged, and global ad spending contracted by 1.2% during 2020 as opposed to the pre-pandemic forecast of a growth of 7%. This is because the pandemic inflicted a global slowdown in economic activity. As a result, the advertisers became more prudent with their spending, cutting down ad budgets, and newer digital merchants hesitated to invest heavily in digital customer acquisition.
Travel Advertising will Resume Soon
Although digital ad spending recorded a YoY decline in growth, it remained relatively strong from the consequences of COVID-19 shutdowns during 2020 and grew 12.7%. However, business verticals like travel, which constitutes a large share in Google search advertising, were among the hardest-hit categories by COVID-19 and contracted substantially. As a result, the travel ad market lost nearly half its value in 2020.
Nevertheless, as the world opens up, travel advertising is poised for rapid growth as brands ramp up advertising to rebuild their relationships with consumers
after the great rupture of 2020. The return of travel advertising budgets will drive revenues to the upside and account for greater advertiser density across Google Services.
eMarketer Forecast (emarketer.com)
YouTube will be Top Growth Contributor
Digital video, most notably YouTube, has displayed meaningful user growth and watch time. Today, YouTube has over 2.5 billion monthly active users (MAU), up nearly 70% since 2015, compared to pay-tv subscriptions, which are down 28%. Remarkably, recent data shows that around 40% of US ad impressions occur on TV devices, a 233% jump compared to two years ago.
In a previous article, I discussed how YouTube's revenues approach Netflix. Not surprisingly, revenues increased by $9.1 billion in 2021, posting a YoY topline growth of 46%. The levers for growth include continued consumer and advertiser shifts to digital video from other traditional formats, particularly TV. Growth during the year was also powered by Youtube’s direct response formats and brand advertising products within rich video content. From now on, growth in eCommerce penetration, increase in digital ad spending, and growth in userbase will continue to be the key trends driving Youtube’s revenue growth.
With a consistently growing user base, YouTube's content distribution increases in value, resulting in more content creators and advertisers signing up. Even though the majority of YouTube's revenue is generated through ads, the company's monetization of YouTube Red and YouTube TV via subscriptions proves the resiliency of its userbase.
Last but not least, a survey conducted by Pew Research Center highlighted YouTube to be the biggest beneficiary of the pandemic among all social media platforms. YouTube and Facebook continue to dominate the social media landscape, while YouTube and Reddit are the only two platforms that have experienced statistically significant growth since 2019.
Therefore, it is evident that YouTube has outperformed other platforms in the broader digital advertising market and will continue to do so in the future with an increase in video content consumption online.
Pew Research Social Media Use (pewresearch.org)
Google’s Cloud Division Remains a Catalyst
Google Cloud revenues increased by $6.1 billion in FY2021, posting an impressive growth of 47% YoY. The growth was primarily driven by the company’s cloud service offerings, including Google Cloud Platform and Google Workspace, which are continuously gaining momentum in the booming cloud computing market. Accelerated by the pandemic, cloud adoption and the transition from in-house infrastructure and storage to cloud products continues to become more mainstream. As a result, the public cloud market is forecasted to grow at 20.4%, reach $494.7 billion in 2022, and expand to nearly $600 billion in 2023.
Worldwide Public Cloud Services End-User Spending Forecast (gartner.com)
Google’s strategic partnerships and acquisitions, and a growing number of data centers, are helping it to expand its cloud footprint worldwide. However, in light of the company’s commitment to growing scale in the large public cloud opportunity, Google Cloud has been a sizable drag on consolidated profitability.
In contrast to Amazon's AWS, which generates 30% EBIT margins, Google Cloud ended 2021 with a negative 16% EBIT margin. However, this was a meaningful improvement from the negative 43% EBIT margin in 2020. In addition, management signaled ongoing aggressive investments given the large yet untapped opportunity within the public cloud. Undoubtedly, margins are expected to improve meaningfully as the business scales, implying a lower drag on consolidated operating margins. However, on a longer horizon, there is no structural reason why Google Cloud's operating margins should not mimic that of its larger peers such as Azure and AWS.
Even though the cloud market has been commoditized and dominated by a few large players, AWS remains the cloud market leader, and up to now, there is no identifiable cost advantage or strong network effect for Google's Cloud offerings. Nevertheless, the company's cloud segment should keep growing at more than a 27% annual rate, and the operational leverage and scale will bring profitability in the near future.
Cloud Market Share (techcrunch.com)
Google’s Mobile Search Gains Momentum
With millions of new users entering the market amid rising digital adoption, especially in emerging regions, many mobile internet devices have made their way into the market. Google seizes this opportunity by improving its processes with initiatives like its Mobile-Friendly algorithm change and product listings. Moreover, developing more efficient search models and integrating AI and machine learning models to make advertising more efficient across all platforms creates a win-win situation for both buyers and sellers on the platform.
Other Promising Investments & Acquisitions
Google’s other bets comprise early-stage technologies that are a part of the company’s core business, but have a high potential for driving future growth in the company. While still early and with limited visibility, Google’s investments address huge addressable markets across transportation and healthcare.
Specifically, Waymo is broadly seen as the leader in autonomous vehicles within transportation. The self-driving car company raised $2.5 billion in a funding round which valued the company at $30 billion. Waymo stated that it would use the funds to advance its Waymo Driver autonomous driving platform, which underpins its autonomous ride-hailing service Waymo One and delivery business unit Waymo Via.
The company has a big opportunity ahead of it in terms of the growing autonomous vehicle market, which is expected to be worth $400 billion by 2025. In addition to the piloting autonomous ridesharing programs in Arizona and California, Waymo recently announced that it would start offering driverless rides in San Francisco. The commercial adoption and increase in scale would translate into a heavy re-rating of the 'other bets' segment of Google.
Last year, Google completed its $2.1 billion acquisition of Fitbit, a fitness wearable company. The company has more than 31 million users worldwide and provides Google a footing in the multi-trillion healthcare market. With access to users’ health metrics via Fitbit, Google is well-positioned to collect insights and launch products into the lucrative health care market.
Therefore, as long as GOOG maintains a healthy R&D expenditure in the range of 12% to 15% of revenues, it is expected to produce superior returns, enhancing its competitive positioning and economic moat.
A Compelling GARP Investment
Over the past years, Alphabet has demonstrated its resiliency and successfully capitalized on the digitalization trends since the pandemic, while its valuation got cheaper. Despite the company's strong growth prospects, the market currently assigns a historically low P/E multiple for GOOG. Thus, the growth prospects and lower valuation multiples support a favorable PEG ratio at 0.24 and signal a unique GARP play.
In my earlier analysis for GOOG, my intrinsic value estimate stood at $3118, and at current levels, the stock offers a wider margin of safety of 21% and an upside of 26%. Undoubtedly, my conservative estimate uses a 5-year annual revenue growth of 14.8% to determine the fair value, even though a 17%-19% rate better matches GOOG's prospects.
What Investors Should Expect from Q1
Finally, with the earnings date around the corner, Jika's traffic analysis tool captures Alphabet's traffic correlation with revenue, providing a sound basis for developing reasonable expectations for Q1. Therefore, after confirming Alphabet domains' strong correlation (i.e., youtube.com, drive.google.com, and others) with reported revenues, I can rely upon certain domains' traffic for Q1's expected performance.
Traffic & Revenue Correlation (jika.io)
More specifically, taking google.com's main domain as an example, it is evident that the traffic volume remained relatively flat in the past quarter. Similarly, performing the same exercise for youtube.com, the volume was relatively stable for January to March 2022.
Thus, traffic data suggest a moderate or flat growth for Q1, though, considering the aggregate nature of data, it cannot suggest an accurate forecast but only a reasonable expectation. For example, YouTube's traffic volume for Q1 stayed stable, but the volume data does not segregate between new or repeating users, which could give a fair estimate of MAU growth. Nevertheless, having access to aggregate traffic volume remains the leading indicator for forecasting the company's quarterly performance.
google.com traffic (www.semrush.com)
Conclusion
Thus, in light of the upcoming earnings results and the market's obsession with EPS and revenue growth, any negative surprise might develop another attractive entry point in the short term. Alphabet's growing userbase, enhanced ecosystem, strong network effect, and strengthening growth prospects provide a compelling GARP investment for the long term.
