Alphabet: A Buying Opportunity (But Might Get Even Cheaper)

Summary

• Alphabet reported solid quarterly results, and despite growth slowing down, revenue still increased over 20%.
• Although we can identify some problems, we should not be too pessimistic about Alphabet.
• But when looking at other businesses like Meta Platforms or PayPal, we have to consider the possibility of lower valuation multiples.
• But the stock appears to be undervalued, and only when using very bearish assumptions, Alphabet's stock might be too expensive right now.

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Last week on Tuesday, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) reported first quarter results for fiscal 2022. And after several other technology stocks declined extremely steep after earnings - PayPal (PYPL), Meta Platforms (FB) or very recently Netflix (NFLX) might be examples - some investors, analysts and commentators seemed to expect (or fear) a similar fate for Alphabet. And Alphabet dropped the following trading day, but only in the low-to-mid single digits and right now (three trading days later) the stock is trading about 3.7% lower.

Although Alphabet is without any doubt a great business and is fitting all the criteria I have for long-term investments, I only covered the company once about three years ago. I was not bearish about the business back then, but I considered the stock overvalued (which might have been a mistake in retrospect as I underestimated the growth potential of the business). When my last article was published, Alphabet was trading for about 35 times free cash flow and with Alphabet trading only for 24 times free cash flow right now, my assessment will be different. But let's start by looking at the last results.

Results

In the first quarter of fiscal 2022, Alphabet could generate $68,011 million in revenue and when comparing this to the revenue generated one year earlier ($55,314 million in Q1/21), the top line was growing 23.0% year-over-year. And as total costs and expenses increased slightly more than revenue, operating income could increase "only" 22.2% year-over-year (from $16,437 million in Q1/21 to $20,094 million in Q1/22). And finally, diluted earnings per share declined from $26.29 in Q1/21 to $24.62 in Q1/22 - a decline of 6.3% YoY.

Alphabet Q1/22 Earnings Release

Earnings per share in the first quarter of fiscal 2021 were higher due to $4,846 million in "Other income", which was mostly due to a gain on equity and debt securities in Q1/21. And as the first quarter was not great for financial markets, it is not surprising that Alphabet had to report a loss. Warren Buffett is frequently pointing out, that we should not focus on earnings per share when looking at Berkshire Hathaway - and similar advice could be useful for Alphabet as the fluctuation of financial markets will also lead to a fluctuation of Alphabet's earnings per share.

Problems for Alphabet?

Right now, Alphabet is trading for the cheapest valuation in its history. The stock is trading for 21 times earnings and about 24 times free cash flow - and these low valuation multiples seem to indicate that investors are rather cautious and see problems for Alphabet. The stock has also entered the bear market territory and declined about 24% from its previous all-time highs.

Data by YCharts

Investors obviously seem to be worried about growth slowing down. And when looking at the last few quarters, revenue growth was slowing down quite dramatically - from about 62% four quarters ago to "only" 23% right now. But we must put these results into perspective and look at bigger timeframes. And when looking at previous quarters, we can see that Alphabet is just returning to pre-crisis (pre-COVID) growth rates. Note the current growth rate is the outlier, the last few quarters have been the exception as Alphabet was outperforming like many other technology companies.

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And especially when looking at the last few years, we can see that Alphabet's top line growth was fluctuating around 20%, which is also underlining that we are just returning to "normal" growth rates right now.

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YouTube

Another reason for concern seems to be YouTube, which is struggling a bit. Revenue from "YouTube ads" could still increase year-over-year, but only from $6,005 million in Q1/21 to $6,869 million in Q1/22 - resulting in 14.4% growth.

Alphabet Q1/22 Earnings Release

And aside from "YouTube ads", "Google other" also reported rather low growth rates (revenue increasing 4.9% YoY) and this segment is also including "YouTube subscriptions". Maybe we should not be worried about growth slowing down as we always have to keep in mind, that we are comparing current results to excellent quarters as Alphabet grew with a strong pace in 2020 and 2021.

Fines and Lawsuits

The biggest part of revenue of the "Google other" segment is coming from the "Google Play Store", and it may also be responsible for growth rates slowing down as Alphabet is clearly facing legal risks. In the past, several different countries have sued Google for app store violations and the result could be high fines for Google as well as much tighter rules. And Alphabet (especially Google) has been sued quite often in the past - for example by the European Union.

Cloud

Some also see the Cloud segment as a problem as the business is still not profitable. The segment still reported an operating loss of $931 million in this quarter (almost the same as one year earlier). But on the other hand, Google Cloud could increase revenue from $4,047 million in Q1/21 to $5,821 million in Q1/22 - resulting in 43.8% YoY growth for the segment. And we can assume that Google can make this segment profitable and it could actually be a driver of growth in the years to come. And although we should not ignore the existing competition, Alphabet is clearly one of the dominant players - along with companies like Microsoft (MSFT) and Amazon (AMZN) - in this market, that is expected to grow with a high CAGR in the years to come (see here and here).

eMarketer

But not only cloud is expected to keep growing in the years to come. Digital ad spending worldwide is also expected to grow in the years to come and Alphabet's core business will profit from that as well. And although analysts might be a little more cautious right now, they are still expecting growth rates in the double digits for the years to come.

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Great Business

And even if growth should slow down in the years to come, we still must keep in mind that Alphabet is a great business with a wide economic moat around its business and the ability to keep competitors at bay. Not only does Android have a 71% global market share in smartphone operating systems, Google Search still can maintain its above 90% market share among the search engines. And while both are a huge competitive advantage, it is difficult to overstate the value of Google Search and the economic moat it is generating around Alphabet.

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We already mentioned that Alphabet could grow its revenue above 20% for many years, but growth by itself is not enough for a great business. Alphabet, however, has also rather stable margins over the last 10 years as well as an average return on invested capital of 15.62% during that timeframe. Both are also indicators for a great business.

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Balance Sheet and Share Buybacks

In the case of Alphabet, we also should mention the balance sheet. But not so much due to debt or liquidity as well as solvency issues - rather due to the huge amounts of cash and cash equivalents Alphabet has on its balance sheet. On March 31, 2022, Alphabet had $14,791 million in long-term debt, but compared to a total equity of $254,004 million (which is resulting in a D/E ratio of 0.06) and an operating income of $78,714 (resulting in 0.2 times operating income necessary to repay the outstanding debt) this is barely worth mentioning.

Much more interesting is the asset side. Alphabet also has $20,886 million in cash and cash equivalents and $113,084 million in marketable securities on its balance sheet. And aside from these rather liquid assets, Alphabet also has $30,554 million in non-marketable securities. The majority of these marketable securities are government bonds, corporate debt securities as well as mortgage-backed and asset-backed securities and are mostly due in less than 5 years.

It seems like Alphabet has much more cash (or equivalents) on its balance sheet than it knows what to do with and this might be the reason why Alphabet started buying back shares. In the first quarter of fiscal 2022, the company spent $13.3 billion on share repurchases, and in the last 12 months, the company repurchased a total of $52 billion of the company's Class A and Class C shares. Consequently, the number of outstanding shares declined again after increasing slightly for several years in a row. From the peak of 705 million outstanding shares a few years ago, the number declined to 667 million outstanding shares now.

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Intrinsic Value Calculation

In the past, I have sometimes provided several different intrinsic value calculations in one article. Usually, I just provide one intrinsic value for a stock, but we all know that it is almost impossible to determine a precise intrinsic value for a stock. It makes much more sense to provide several different scenarios and in the case of Alphabet, I will provide a base scenario (the most realistic assumption), a bullish scenario and a bearish scenario. And in all three cases, I will use a discount cash flow calculation.

Let's start with the bear case scenario. As analysts are expecting Alphabet to rather stagnate in fiscal 2022, we take the free cash flow of fiscal 2021 as a basis ($67,012 million). And as a recession in fiscal 2023 seems a possibility, we will not only assume a slowdown for the business but a 20% decline in fiscal 2023 and another 10% decline in fiscal 2024. After a recession, Alphabet will probably bounce back, and we expect 20% growth in fiscal 2025 and 10% growth in fiscal 2026 followed by only 6% growth till perpetuity. When calculating with these assumptions (and a 10% discount rate as well as 667 million outstanding shares), we get an intrinsic value of $1,900 for Alphabet and the stock would still be overvalued.

Next, let's look at our bull case scenario with extremely optimistic assumptions. We assume, that there won't be a severe recession or that it has no impact on Alphabet's business. Nevertheless, we must assume that growth will slow down over the next few years and growth rates will decline from 20% in fiscal 2023 to only 6% growth in 10 years from now. We also assume 6% growth till perpetuity in that scenario and with all other assumptions similar as above, we get an intrinsic value of $4,091 for Alphabet.

And finally, the scenario I would consider the most realistic - my base case scenario. While this scenario is also assuming a recession, we only see stagnating free cash flows in fiscal 2023 and fiscal 2024. For fiscal 2025, we see 20% growth again, which will slow down to 6% growth in fiscal 2030 and stay at that level till perpetuity. With all other assumptions being similar again, this leads to an intrinsic value of $2,981 for Alphabet.

A few final notes:

• Alphabet is indicating that it will increase spending and invest in the future, which might lead to higher capital expenditures. And higher capital expenditures will lead to lower free cash flow.
• But we also must consider that Alphabet has a lot of cash and cash equivalents on its balance sheet. When subtracting $14,791 million in debt from cash, cash equivalents and marketable securities, we get $119 billion in very liquid assets, that could be distributed to shareholders. This would, for example, result in a special dividend of almost $180 and although I am not saying Alphabet should pay such a dividend, that amount should be included in our calculation and the intrinsic value for Alphabet in our base scenario should be rather $3,160.

Fundamental Business vs. Stock Price

From a fundamental point of view, Alphabet seems to be undervalued - or almost fairly valued when assuming a difficult road ahead for Alphabet. And as a long-term investor, I am convinced that short-term stock price movements don't matter. But we must acknowledge that many companies with solid fundamentals declined extremely steep in the last few months. PayPal is trading for 18 times free cash flow, Meta Platforms is trading for 13 times free cash flow and Baidu (BIDU) - the Chinese equivalent - is trading for only 12 times free cash flow.

Data by YCharts

We can always make arguments why Alphabet can't be compared with Facebook or with Baidu or Alibaba (BABA). But there is absolutely no reason, why Alphabet should not trade for only 15 times free cash flow as well. Right now, sentiment for Alphabet seems to be much more positive than the sentiment for Facebook or many Chinese technology companies, but that might change - we never know. When looking at the articles published so far about Alphabet, many contributors seem to agree that the fears are overblown. But I also consider the fears for Meta Platforms, Tencent (OTCPK:TCEHY) or Alibaba way overblown, and the stocks declined nonetheless.

A good example for sentiment vs. fundamentals and the irrationality of the market would be the stock split, that many technology companies announced recently - including Alphabet which will split 20:1 effective July 15, 2022. While (almost) everybody seems to understand that a stock split should not change the price we are willing to pay for a stock, Mr. Market was behaving very differently.

Conclusion

In my last article, I was not so bullish about Alphabet and saw the stock rather overvalued. But now, my opinion changed, and I would consider the stock undervalued and rather a bargain at this point. However, it is possible, that the stock will decline further. The fundamental side in me is arguing for buying the stock right now, but there is also a voice screaming to wait a little longer as Alphabet might drop much steeper.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of BABA, FB, TCEHY either through stock ownership, options, or other derivatives. 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.