$GOOG, $GOOGL, advertising, Alphabet, artificial intelligence, autonomous driving, Buffett, DeepMind, economic moat, Google, Larry Page, machine learning, mobile, network effects, search, Sergey Brin, YouTube
Last month, I posed a serious question:
Just days later, we got our first hint that Buffett himself was buying Apple! Followed shortly after by that bombshell CNBC interview (here’s the transcript), where he revealed an $18 billion+ Apple investment*, the vast majority bought by him in Jan/recent months (& the rest by Todd/Ted in early-2016). What better confirmation of my assertion that value investors – even the greatest of them all, at 86 years of age – would be wise to pose such a question to themselves!?
[*Pretty sure Apple is Buffett’s largest common stock investment ever (on a cost basis). In fact, I wonder if it’s the largest stock investment ever made by a single investor (again, in terms of cost)? Sure, Todd/Ted/Charlie did provide some inspiration/feedback here, but we can be damn sure Buffett never buys anything ’til he makes his own mind up! So: Your thoughts/feedback?]
Granted, I got lucky…
Was I confident I’d see Buffett talking up an Apple position just weeks later? Um, no… [Don’t forget, Icahn announcing a multi-billion holding some years back was a huge surprise too!] And maybe I chose it specifically as the largest & most obvious/controversial value stock out there. Not to mention, the head fake I pulled: While I did summarise its attractive fundamentals/valuation, my post clearly wasn’t intended to be a detailed thesis. But hey, it was still the right question at the right time, so I’ll take the kudos!? And Buffett’s purchase now serves as great inspiration to present a genuinely compelling investment thesis here. Yeah but, just not Apple – I mean, who even needs a thesis right now when Buffett’s put so much money where his mouth is?! Instead, we’ll focus on a company which is arguably the antithesis of Apple – therefore, I ask:
So Why Not Google It..?
Yeah, it’s Alphabet Inc. (GOOGL:US, or GOOG:US). While the new holding company moniker isn’t so recognisable, almost everybody on the planet interacts with its products – on a daily basis – Search, Android, Maps, Chrome, YouTube, Google Play & Gmail each have over 1 billion monthly active users! Obviously, no introduction’s needed here, but if you haven’t read them recently, I recommend two key documents: ‘An Owner’s Manual’ for Google Shareholders, from the 2004 IPO (inspired by Buffett), plus the Alphabet Letter, which details the 2015 transition to a holding company for Google & Other Bets (again, inspired by Buffett!). Note particularly the core ‘mission statement’:
‘Google is not a conventional company. We do not intend to become one’
But while we love Google’s story & product(s), many haven’t considered it any more seriously as an investment than Apple. You know why…in no particular order: It’s a tech-company, it’s a tech-company that’s totally dependent on ad-revenue, its costs-per-click keep falling, many products/services have completely bombed, its talent could & probably will walk out the door tomorrow, it’s pissing money away on moonshots, it could be superceded by a better mouse-trap tomorrow, its CFO is an over-compensated innovation-killer, it’s sitting on mountains of idle cash, its dual-share structure is evil, it belongs in the too-difficult pile, it’s a black box, who bloody knows, etc. OK, breathe…
In reality, the list tells you as much about the biases of investors themselves – such objections aren’t necessarily correct, or even grounded in facts/figures. Which we’d do well to focus on – here’s the last decade of Alphabet/Google results, complete with 5 & 10 year CAGRs:
Focusing on the last 5 years, revenue growth’s slowed marginally, but nobody could fail to be impressed by the consistent top-line growth of 19% pa. Unfortunately, non-GAAP operating margins have failed to expand as one might expect – in fact, they’ve gone into reverse, declining from 36% to 34%. Which is exacerbated by a progressively more generous stock-based compensation (SBC) policy in the last few years. Taken together, GAAP operating margin’s grown 15% pa. And like most tech companies, stock issuance along the way leaves diluted/ex-SBC diluted EPS growth at 13-14% pa. Not to be sneezed at in a post-crisis world…
But if you weren’t an Apple fan (despite its earnings trajectory), you just might hate Alphabet – which boasts lower 5-10 year earnings growth, yet manages to enjoy a far higher multiple?! At today’s $868.39 $GOOGL price, Alphabet trades on a 25.3 non-GAAP P/E (vs. 2016 ex-SBC diluted EPS of $34.34). And if that turns you off, doubtless you’ll focus on the much higher 31.2 GAAP P/E (vs. diluted EPS of $27.85). Of course, more adventurous growth investors don’t even blink at such numbers…but for the average value investor, on the face of it, these P/Es are likely way too steep to even consider (in absolute, relative, and/or PEG ratio terms)!
But such a conclusion could be a huge missed opportunity…
We need to survey the company through different lens – focusing instead on three distinct components of Alphabet’s corporate empire, while making one additional but critical accounting adjustment, to apprehend a more realistic picture of the company’s performance, prospects & underlying fair value. First, we have:
A Ton of Cash & Investments:
Too many investors discount cash…while over-estimating the advantages of debt. [Look at any great growth story, debt’s not the driver!]. But a strong balance sheet may permit a more aggressive/long-term strategy in a company’s existing business, whilst retaining a free option on future growth opportunities. Conversely, an over-leveraged company may quickly find its horizons limited & its options eliminated. Of course, discounting cash (& investments) may still be warranted, if management’s intent on: i) building a permanent cushion of idle cash, and/or ii) pursuing illogical/value-destroying acquisitions & investments (or has a history of such indulgence). I don’t believe investors face these risks with Alphabet.
In terms of internal investment, Google’s the answer – from a single web page, Larry Page & Sergey Brin built a search & advertising colossus from scratch! While presiding over an acquisition machine, with 200+ acquisitions since day one. [And here’s a fascinating Google timeline…but as your mother said, you may go blind!?] Notably, the majority of deals have focused on acquiring talent, technology & intellectual property – not existing revenues/profits – to support/build on existing businesses & expand into related fields. But surveying some of the largest deals, they’ve been total block-busters! Android in 2005 (for just $50 million!?), YouTube in 2006 ($1.65 billion!), DoubleClick ($3.1 billion) & AdMob ($0.75 billion) in 2007/2009. As for Waze in 2013 ($1 billion), and Nest Labs in 2014 ($3.2 billion), it’s still too early to tell.
And Alphabet’s largest deal, $12.5 billion for Motorola Mobility in 2011, was also notable: First, it wasn’t the failure some have tagged it. Motorola had almost $3 billion of cash at the time, Motorola Home was sold for $2.4 billion, then Motorola Mobility for another $2.9 billion, while deferred tax assets appear to have more than offset interim operating losses – and so, apparently as intended all along, Alphabet effectively acquired Motorola’s entire patent portfolio for sub-$3.5 billion, to ‘defend the entire Android ecosystem’. Noting Android’s smartphone dominance ever since, offence may be the more accurate term than defence!? [By comparison, Apple/Microsoft/RIM bought Nortel’s patent portfolio for $4.5 billion, also in 2011]. And second, the gross Motorola consideration is actually less than 50% of the annual $26 billion free cash flow (FCF) Alphabet now generates!
Clearly, Alphabet’s current acquisition/investment strategy is value-enhancing, but even snagging a few decacorns won’t put a serious dent in its growing cash pile! A step-change in strategy is required, i.e. larger/listed targets, with revenues/profits/users being the primary driver. But I’m not convinced that happens anytime soon – as it surely requires Alphabet to become just a little more evil..!? [‘Evil’ is confusing, now I just substitute ‘corporate’]. Returning cash to shareholders is the obvious alternative – and right now, I’d bet it’s a far more likely outcome. And the transition to a holding company structure heralds a greater focus on capital allocation, with Ruth Porat adding an external perspective. [She’s called Ruthless Ruth, reflecting the silly notion she’s a bull in a china shop. But her hiring was clearly integral to the Alphabet road-map – doubtless, she has Larry/Sergey’s full backing. And Larry never liked saying no…now he’s got Ruth to do it!] While Alphabet hasn’t signaled a dividend, it did complete (its first) $5 billion+ share buyback in 2015/2016, and recently approved a new $7 billion buyback programme.
Repatriation would be the real catalyst here – for (say) a much larger tender offer – the company now has $52 billion of cash re-invested overseas. I think this is inevitable, but now appears far more likely/imminent under Trump. [In fact, a 15% (or even higher) tax rate up-front would eliminate a repatriation bill – companies could just take the incremental tax hit. Either way, the tax bill’s only a few months of FCF for Alphabet]. And speaking of catalysts, it’s a brave new world out there for tech companies – activist investors now have an appetite for targeting & harrying even the largest of tech companies to declare a dividend, do a spin-off, buy back shares, or even take on debt.
Meanwhile, Alphabet has $13 billion of cash & $73 billion of securities (primarily in treasuries/sovereign bonds/agencies). Also: i) $6 billion of investments – any volatility/illiquidity is more than offset by $5 billion+ of unrecorded revaluation gains, ii) $1.4 billion of Lenovo promissory notes due in October – their balance sheet/cash flow suggest no reason to doubt this will be paid, and iii) a recently announced $0.8 billion for a non-controlling stake in Verily – the final tranche to be received in H2-2017. Anyone nit-picking these figures should remember Alphabet’s generating $2.2 billion FCF per month! So while we’re at it, it’s also reasonable to include an additional $5 billion+ of FCF YTD:
$12.9 Billion Cash + $73.4B Mktble Securities + $5.9B Inv’ts + $1.4B Pro Note + $0.8B Temasek Deal + $5.3B FCF YTD = $99.7B Total Cash & Investments = $145 Cash & Investments per Share
That’s a round $100 billion – like I said, a ton of cash & investments!
Other Bets – Moonshots & Unicorns:
Sequoia Capital, Benchmark, Kleiner Perkins Caufield & Byers, Andreessen Horowitz, Union Square Ventures, Index Ventures, Y Combinator…how many investors would give up their first-born just to invest in these unicorn
farms firms?! Yep, they’re the some of the best & brightest VC firms in the world, and have the unicorns & IRRs to prove it. At best, you’ll face a near-impossible set of hoops (& possibly several layers of fees), to invest in their funds – at worst, it’s actually impossible.
Why not consider Alphabet instead..?
From day one, Google told its shareholders to expect ‘smaller bets in areas that might seem very speculative or even strange when compared to our current businesses’. With the creation of Alphabet, it has now carved out most of these moonshots into a segment called Other Bets – which includes Nest, Google Fiber, Verily, Calico, X, Waymo, GV & Capital G. As any VC worth his IRR will tell you, finding unicorns is all about identifying the best teams (smart, passionate & experienced founders/managers/employees), the largest & fastest growing opportunities (the biggest markets & broadest demographics), and then (& only then) the best business model to generate revenue & ideally profits (monetising needs/wants/eyeballs). Given Alphabet’s record of investment & value-creation to date, its ability to attract many of the smartest & most talented people in the world, its targeting of some of the largest markets on earth (or possibly even space!?), I’m willing to bet its Other Bets unit may potentially offer one of the best unicorn farms in the world!
And what better confirmation of Page/Brin’s faith in these moonshots – they chose to pursue them in-house, regardless of cost (that’s now changing). And cost is critical here: Invest in a VC fund & you will record an asset on your (personal) balance sheet, as would Alphabet making external investments in companies & VC funds. But investing in its own moonshots in-house, the rules dictated it record a pre-tax $3.6 billion P&L loss* last year…not a balance sheet asset!? Yes, accounting’s sometimes that arbitrary… [*Reflecting Other Bets early-stage revenues, which are fast-growing but still minimal (i.e. less than 1% of Alphabet’s total revenues), vs. its current expense base]. Here’s what it looks like over the last 5 years:
Yes, as I’m sure you know, these misleading losses are the culprit behind Alphabet’s margin erosion/earnings shortfall (vs. top-line growth) in the last 4 years. And while Porat appears to be imposing more budgetary/investment discipline now, I wouldn’t necessarily expect much reduction in losses in the near-term – any scaling-back of expense/ambition in one area will likely be redirected into other more promising bets. But as of today, for an Alphabet investor, a cumulative $9.5 billion of Other Bet losses have been fully expensed, but still offers a potentially very valuable free option. And also, ongoing losses should be treated as investment – i.e. an asset. Which I suspect presents limited financial risk: Actual cash losses, net of tax, should remain a fraction of overall FCF, while ongoing investment is justified if Other Bets can boast/sell/spin-off a decacorn (say) in the next 3-5 years. [Notably, Snap Inc. (SNAP:US) is a loss-making company which generated $0.4 billion revenue last year (precisely 50% of Other Bets 2016 revenue), but is worth $24 billion today!?]
And so, Other Bets losses will be ignored here, with no Other Bets investment asset being created/included for valuation purposes either.
The Cash Machine:
And last but definitely not least, we have the Cash Machine itself, as Googlers sometimes call Google. Having confirmed Alphabet’s cash & investments, and re-classified its Other Bets losses as potentially highly valuable VC investments, we can finally evaluate its core business, i.e. Google’s valuation on a stand-alone basis. But we still need to make some minor adjustments, plus one final essential accounting adjustment. First, here’s Google’s last 5 years:
[NB: Unallocated corporate costs (approx. $0.6 billion pa) are included here, so revenue/operating income in Google & Other Bets tables fully reconciles back to consolidated Alphabet table at beginning of this post.]
[NB: First table above details Google’s advertising segments, then advertising & other segments. While the second table details Google’s total revenues/etc.]
What a thing of beauty… Advertising revenue growth from Google’s core properties – Search, YouTube, etc. – has averaged 20% pa, despite significant headwinds (annual declines in costs-per-click) from the ongoing transition to mobile. The laggard is revenues from ads placed on external Google Network Members’ properties (via AdSense/AdMob/DoubleClick) – revenue growth’s been throttled by the same costs-per-click decline. However, this has been essentially offset by the extraordinarily rapid (49% pa) growth in other revenues, i.e. Google Play (net revenue), hardware sales, Google Cloud services, etc. Google revenues overall have grown 19% pa, which obscures a consistent 20%+ constant currency growth rate (in fact, averaging 22% pa). Again, a general increase in stock-based compensation (SBC) has marginally reduced operating income growth to 18% pa, noting a stable 31% GAAP operating margin in the last couple of years.
The obvious issue here is whether to focus on GAAP or non-GAAP (i.e. ex-SBC) operating income. Wall St is perfectly comfortable with the latter, and usually I’m happy to ignore SBC too: On the basis it’s a non-cash expense, it vests (or expires) over a number of years, it may be dependent on specific performance & share price targets. Not to mention, as I re-iterate my fair value analysis over time, I’d expect future dilution (unless SBC’s really excessive) to be (more than) offset by future revenue/earnings growth. But in this instance, I’d note the following:
[NB: I had to presume all intangible asset expenditure was acquisition-related, and therefore ignore it in the table above.]
Actual capex substantially exceeds current depreciation/amortisation expense – so, despite no SBC cash cost, Alphabet’s FCF is only marginally higher than GAAP net income (on average) over the last 5 years. [Obviously, absent this additional capex, FCF would be even more impressive!] While we might expect this gap to close over time, it’s prudent to focus accordingly on Google’s 31% GAAP operating margin (i.e. assume it also corresponds to underlying cash flows). [NB: Alphabet just confirmed it will no longer provide ex-SBC earnings (though Wall St will probably still derive them]. But noting the current growth momentum, we can anticipate a current revenue/earnings run-rate. While Wall St is happy to reference 2017 & even 2018 estimates at this point, I’d normally gross up the latest quarter to arrive at a reasonably conservative annual run-rate. However, Google revenues exhibit a seasonal pattern, rising each quarter to reach a Q4 peak at 29% of annual revenue (I see no operating margin seasonality). Therefore, noting 22% & 24% actual/constant currency growth rates in Q4, let’s split the difference twice – i.e. use a 23% average growth rate, then halve it – for a conservative 11.5% uplift in revenues. Using the same 31% operating margin, we apply Alphabet’s 19% effective tax rate (3 year average), to arrive at:
Which puts Google on revenue of $99.7 billion, precisely equal to total cash & investments (a coincidence Page/Brin would presumably love!?), and a net earnings run-rate of $24.6 billion – for an ex-cash 20.2 earnings multiple (remember, this is post-SBC).
Unfortunately, we essentially face the same accounting issue here. After centuries of accounting for purely tangible assets & value creation, the accounting profession still refuses to properly appreciate the fact intangible assets have been responsible over the last 50-100 years for an ever-expanding slice of the pie, in terms of economic & corporate value-creation. [Haven’t come across a copy yet, but I suspect ‘The End of Accounting’ is the best read going on this entire topic]. So the vast majority of corporate research & development/intangible asset expenditure continues to be treated as expense, not an investment. Which has its pros & cons: Investors mostly adjust accordingly (i.e. reverse out some/all of this intangible expense), which explains why intellectual property companies (as in technology, media, pharmaceuticals, etc.) often trade on steep earnings multiples vs. the rest of the market. But occasionally, in certain sectors/companies, investors seem to lose sight of this earnings suppression – which can throw up some real bargains…
I tend to split the difference by adding-back half a company’s intangible expenditures (excluding acquisition-related investment), or possibly two thirds if it has a strong record of innovation & value-creation, to arrive at a more sensible underlying earnings number. Obviously, some R&D/intangibles will never have value, much will have value only for a year or two, but some may turn out to have enduring value for decades to come – my implied amortisation, over 2-3 years, seems appropriate, or maybe even conservative. Again, I enjoy the potential future benefit of all intangible expenditure expensed to date (though bearing in mind some future revenue/earnings decline may occur as historic intangible investment no longer supports/contributes any value).
In this instance, Laszlo Bock’s ‘Work Rules!’ inspired me (surprisingly, far more than Schmidt’s ‘How Google Works’). Google’s famous 20% time may no longer exist, but as Bock says, that doesn’t really matter ‘as long as the idea of it exists’. I’ll certainly run with that – employees may no longer literally carve out a day each week to mess around with stuff, but Google obviously remains committed to huge investment in its core business, continually ranking & allocating more (or less) resources to products/services which are often still pre-revenue, margin-free, or even plain old loss-making… [YouTube is a prime example – it is, by far, the largest streaming business globally (over 1 billion users per month), but appears to be only in the early innings now of generating revenue, let alone margins. As Google’s CEO Sundar Pichai recently stated, ‘we believe [it’s] only begun to scratch the surface’].
And so, if we treat 20% of operating expense (on average) as intangible investment, we’re talking about $13.9 billion. [Disagree with this approach? Note Alphabet’s current R&D run-rate’s probably about $2 billion higher at $15.7 billion (an average 15.6% of revenue over the last 3 years)]. Then if we back out two thirds of this expense (net), we have:
We arrive at a far more accurate picture of Google’s underlying earning power – a 40% adjusted operating margin, and adjusted net income of $32.1 billion, which puts Google trading on an adjusted/ex-cash 15.5 earnings multiple (again, this is post-SBC). Which I think is an astonishingly cheap multiple for Alphabet’s core business (which still represents over 99% of consolidated revenue!), in light of its consistent 22% pa (constant currency) revenue growth in the last 5 years & obvious future revenue/earnings potential.
For a minute, compare Google’s trajectory to that of Unilever (ULVR:LN). Now consider this fascinating Lindsell Train analysis (published prior to the Kraft Heinz bid): Investors appear to vastly underestimate the value of consistent compounding – one could have paid a 46 P/E for ULVR 20 years ago & still have achieved market returns since!
The lesson, of course, is not to focus unduly on the current multiple, or even your fair value estimate…your primary focus should always be on the potential for consistent compounding. Which means getting comfortable with the depth & width of Alphabet’s economic moat… Applying one of Buffett’s favourite tests is a great place to start:
If I gave you $10s of billions, maybe even $100 billion, could you take on & beat Google’s leading global position in Search?
Google’s global share in desktop search is an astonishing 81% – the rest just exist because of China, purchased access/market share deals, and user inertia. Mobile search offers no such places to hide, hence Google’s share is a truly astounding 96%. Also being globally dominant in desktop browsers (Chrome, 59%), and mobile operating systems (Android, 67%) have helped protect & grow Google’s position. Do you really want to take on that kind of dominance? OK, well it’s not just the money, where do you get the people…they probably already work for Google, and a larger compensation package in a brand new search company probably won’t entice them. And even if you scrape together a team, what exactly are you going to build from the ground up? What data/queries/etc. are you going to use to help build/test/improve your search engine? How will you map & access the entire web to feed the beast? How do you plan to roll it out in 100+ different languages? And if somewhere down the road you’re finally ready to go live – how many years is it now – how do you actually intend to attract even a small slice of all those captive Google search users?
Wait, I have one more question: What do you think Google was doing while you were holed up in your office for the last few years? Resting on its laurels? I think not. Oh, and did I mention:
‘Google’ is also a verb…
OK, why not give the money back, eh?
And who better than Charlie Munger to remind us:
‘Google has a huge new moat. In fact I’ve probably never seen such a wide moat.’
That’s the beauty of search – its format may change, but the need for search doesn’t. In fact, its fueled by population growth, expanding access to the internet, the continued migration online (& the decline of TV & newspapers), and in turn to mobile/smartphones, and most of all the iterative human addiction for more & more info/answers/entertainment. Not to mention the network effect of search itself – more searches will produce better searches which produce more searches. [And the same is true of machine learning – the more data, the more input, the more variety, the better the learning – Google’s current search remit gives it a huge edge on its potential rivals who are perhaps working with much more specialised data sets/universe.]
Google has built an advertising colossus on the back of this search engine dominance & user growth. Together, Google & Facebook now control about two thirds of the digital advertising market, and are essentially sharing all new growth between them. Of course, this is nowhere near being a mature market, with old media still hanging on grimly to a totally disproportionate share of advertising (vs. consumers’ viewing/consumption habits today), mainly due to corporate & ad agency inertia. Which adds another huge tailwind of growth, compounded by the explosion in mobile advertising in just the last few years. There’s also a land-grab element to all this – people wring the hands over declining costs-per-click, but that’s only natural (& obviously more than offset by clicks paid growth) – increasing the digital advertising pie & grabbing as large a slice of the pie as possible is what matters now. And when that finishes, I guarantee you’ll see a very different pricing scenario emerge for advertisers…
Then longer term, there’s a whole other land-grab ahead – Alphabet’s US revenues still represent 47% of total revenues, about double the US share of world GDP – that would suggest huge/long term upside growth potential in digital advertising revenues across the rest of the OECD, and particularly in emerging/frontier markets (which are now leap-frogging straight into the digital/smartphone age). Of course, another reason for this is Alphabet’s virtual absence from China – a huge untapped opportunity that potentially awaits – if Google was any other company in the world, i.e. just a little bit more evil, they’d buy Baidu (BIDU:US) first thing tomorrow morning & justify it (to China – I suspect all other stakeholders would love the deal, or simply not care) as a stand-alone non-integrated acquisition.
Of course, the same story is now unfolding with YouTube. People marvel at the latest user numbers from Spotify & Netflix (NFLX:US), but they’re totally dwarfed by YouTube’s 1 billion+ users, to which it’s only now/recently started to roll out channels, studio-based shows & original content, YouTube Red, Live TV, etc. If you want to target Millennials, or Gen Z, they aren’t watching regular TV & they certainly aren’t reading newspapers – the killer app is now video. And, of course, video ads… On your smartphone. Again, I’ll highlight this Barrons piece on YouTube – the numbers are really astonishing – but looking at some of the valuations already out there in the market, I can’t necessarily disagree YouTube (plus Google Cloud, and possibly other units too) would likely get valued at significantly higher sales multiples than Alphabet currently commands.
In the past, this may have been academic, but now Alphabet has a holding company structure (& also a top Wall St CFO) that’s specifically designed to focus on capital allocation & to empower its units to actually innovate, thrive & grow as independent entrepreneurial businesses…ideally on a stand-alone basis. And as they grow bigger and/or head in different directions, Alphabet doesn’t necessarily have to grow (or abandon) them any longer – at times, it may make far more sense, in terms of strategy and/or valuation, to sell or actually spin them off as listed entities (ideally, as unicorns & decacorns!).
And looking ahead, while I still have my doubts whether Alphabet will embrace a step-change in its acquisition strategy (i.e. target larger/listed), I’m not sure it matters. We’re getting closer & closer to an always-on world – where computing genuinely does become a utility, like electricity. Almost all of the Google bets & Other Bets are stitching together the potential to provide cloud-based, always connected (via car, mobile, wi-fi, Internet of Things), artificial intelligence/machine learning & even augmented/virtual reality.
For the world, that means universal simultaneous voice/translation. For individuals, it means entertainment, education & personalised assistants. And for corporates, it means predictive data analytics & cyber-security. Linked to all of this, we have Alphabet’s huge moonshot initiatives in autonomous driving, health & life sciences, and the wired home. [Education is the obvious missing moonshot…OK, now there’s an acquisition opportunity!?] And while I think Google’s presided over the most valuable artificial intelligence the world’s ever known (forget the actual advertising revenues & benefits, think of the incredible time savings & daily benefits the human race derives daily from search itself every single day!?), I suspect its DeepMind acquisition could eventually prove hugely valuable too. [And the mind boggles if they can also bring quantum computing into the equation!]
OK, that’s about enough future fun & frolics – now let’s pull together a fair value estimate for Alphabet. I promise it’ll be painless, all the building blocks are now in place. We already have $100 billion of cash & investments. And we’re treating Other Bets losses as venture capital investment (and ignoring all related revenue/losses/assets). Which just leaves Google – here, I’ll average two separate approaches: A growth-based P/E valuation, and a more static/mature P/S valuation.
i) Google’s delivered 18% pa operating income growth over the last 5 years, despite significant FX headwinds. I’m pretty confident its economic moat is deep & wide, and its growth prospects over the next few years are as just as good, if not better. You can do the math, look at some of the market multiples, review that Unilever analysis again, but you know that a 30-40 P/E could just as easily be justified (or actually attained…in due course). Stick-in-the-mud I am, I’ll opt for/limit myself here to a 20.0 P/E fair value multiple, based on the $32 billion adjusted net income I derived above (though I’ll assure you, I don’t consider that an actual exit multiple).
ii) Mature operating margins of 50-60%+ for Google’s core business wouldn’t surprise me in the least, but let’s stick to the 40% adjusted operating margin I identified above. Which deserves a 5.0 P/S fair value multiple – again, I believe I’m being pretty conservative, in light of some of the market multiples out there for similar high margin (& many lower margin) companies! Obviously, a more mature Google could harness substantial debt capacity cheaply, with essentially zero impact on its market valuation – to fund buybacks/acquisitions/etc – therefore, let’s incorporate some of that capacity into our valuation. To better reflect actual cash flows, this time we’ll reference Google’s 31% GAAP operating margin: The company could add $91 billion of debt & comfortably maintain 6.7 times interest coverage (assuming a 5% long-term interest rate) – as usual, I’ll apply a conservative 50% haircut & deduct current outstanding debt of $3.9 billion, to arrive at a $42 billion debt capacity adjustment. And so, putting it all together:
$99.7 Billion Cash & Investments + Zero Other Bets Rev/Losses/Assets + ($99.7B Run-Rate Revenue * 5.0 P/S + $41.7B Debt Adjustment + $32.1B Adjusted Net Income * 20.0 P/E) / 2 = $691B / 688M Shares = $1,003.87 Fair Value per Share
Rounding, that’s a $1,004 FV per Share & an Upside Potential of 16%.
Which might seem insane…we’ve come all this way for 16%?! But again, this fair value estimate is a much less important component of any analysis & investment – it’s all about Alphabet’s ability to continue growing revenue & compounding earnings/value. Now, sure, I could map out a ‘precise’ growth trajectory for Alphabet over the next five years & a future/target share price, but that just offers up a hostage to fortune… And anyway, anybody who wants to buy the shares needs to ponder this trajectory for themselves. Suffice to say, in the next few years, I believe Alphabet will be a compelling/market-beating investment opportunity under most scenarios. To reference Buffett, you can’t buy a great business cheap, but my fair value estimate & upside are a reminder you can occasionally buy a great business at a fair price!
Investors can choose from the Class A shares (GOOGL:US) which have 1 vote per share & trade at a 2.5% premium (close to the average 2.4% premium since 2014), or the Class C shares (GOOG:US) which have no vote. Some will simply opt for the C shares & never worry about a premium – fortunately, further share buybacks will target C shares, but conversely they’re also Alphabet’s currency for employee compensation & potential acquisitions. As for the A shares, some will argue their votes have no incremental value, since Page/Brin/Schmidt still have majority control via the super-voting power of their unlisted B shares – but if you think a dual-share structure’s a bit evil, just a touch more evil might see significantly different values attached to each share class in some value-realisation event! Then again, what are the chances of such an event? In all likelihood, the outcome for an A shareholder probably isn’t any different than a C shareholder – they eventually sell their shares at some point in the market, at much the same premium…
As for the charts, they both tell the same message: See here & here. Alphabet shares appear to trace a pattern over the years, alternating between distinct consolidation & rally phases, often lasting 1-2 years at a time. And in terms of that timing, and the current price, we may be on the verge of a critical departure right now – the shares are currently breaking out to new all-time daily/closing highs. If we actually see a sustained break this week…I wouldn’t be at all surprised to see a $1,000+ share price melt-up from here, in short order.
I now have an 8.5% portfolio holding in Alphabet Inc., and I specifically own the Class A shares (GOOGL:US).
- Alphabet Inc. (GOOGL:US): $868.39 per A Share
- Market Cap: $598 Billion
- GAAP P/E Ratio: 31.2
- Non-GAAP P/E Ratio: 25.3
- P/S Ratio: 6.6
- Ex-Cash P/S Ratio: 5.5
- Target Fair Value: $1,003.87 per Share
- Tgt Mkt Cap: $691 Billion
- Upside Potential: 16%
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Daniel at banksinasia.com said:
Good that you take up Google as a subject. I have thought of that myself.
Thanks, Daniel…$GOOGL looking good since!
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21-Mar-2017 (per Twitter @Wexboy_Value)
A good day…..have increased my portfolio holding in Alphabet $GOOGL from 9.2% to 10.0% now.
philip rosenau said:
Which holdings were reduced to make space for the grand G
Hi Philip – if you check my disclosed holdings, they’ve actually been falling as a % of my total portfolio* in the last year or more. So $GOOGL was a newly disclosed holding (as of March), but did not actually displace (i.e. reduce/eliminate) any of my other previously disclosed holdings.
NB: I do report any significant changes in disclosed holdings in a timely manner on Twitter & in blog post comments.
[*Which doesn’t mean I was consistently building cash in my portfolio: As I’ve flagged along the way, I generally prefer to average in to a wide selection of holdings over time. And I tend not to disclose a holding until I’ve reached at least a minimum target allocation. Which can take a significant amount of time & energy, and substantial portfolio re-allocation – for example, if I was simultaneously building up six new holdings of 5% each (on average), that might well imply investing/re-allocating a full 30% of my portfolio (and my portfolio turnover’s generally low & slow) before I finally start disclosing any of those positions here. Of course, you’re now starting to see the outcome, with three new investment theses/holdings disclosed here in March-May.]
Imran Siddiqui said:
This has to be one of the best pieces of equity research I have ever come across (and I read at least 5 hours a day). You have outdone even yourself with this one. I have decided to increase my position size. I wonder if you have seen Whitney Tilson’s lecture (in 2014) as part of the Talks at Google Series. Here’s the link to the video on Youtube:
Tilson starts his story on having made the most spectacular mistake of his investing career by dismissing GOOG as an investment in 2004 because the valuation seemed too rich (200x trailing earnings and 12x Sales) and he deemed the moat to be “shallow and narrow”. There’s a great lesson to be learnt here.
Thanks again for an enthralling read.
I do hope that you will find the time to read my SBUX piece and let me have your thoughts.
Warm regards and best wishes
Watched the video (and replied to you elsewhere, I think), but never thanked you for your generous words & ‘review’ here, plus the video link itself.
Yeah, in the end, (almost any) valuation is only ever a problem when it’s actually an average/bad business… That’s why I love the Unilever & similar look-backs/analyses: http://www.lindselltrain.com/~/media/Files/L/Lindsell-Train-V2/investment-insights/2017/Confounding%20Compounding%20-%20February%202017.pdf It really is amazing you could pay up so much for what is generally perceived as a slightly dull company/stock & still make a great return. Which, of course, implies astronomical valuations are possible & even sensible for long-term super-charged growth!
Alas, the obvious challenge for all of us is: i) how to (reliably) find those long-term high-quality/high-growth companies, and ii) then overcome your natural aversion to a valuation that’s a large premium or even a multiple of the market average…
17-Mar-2017 (per Twitter):
PORTFOLIO CHANGE: $GOOGL has now consolidated round a $750 share price average for the last 18 mths…and this week/month’s the break/rally. I’ve now raised my portfolio holding from 8.5% to 9.2%.
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Great write up ! Love your writing style and analysis. Very intuitive. Well done. Need more of this in the world.
WILOWallStreet – many thanks – come back & visit again!
Sometimes I think Google gets a bad reputation among value investors because it is part of the FANG stock group. Good write up!
Thanks, Pugvestor – too right!
“If I gave you $10s of billions, maybe even $100 billion, could you take on & beat Google’s leading global position in Search?”
The great thing here is that Microsoft have tried this with Bing — and failed. (I don’t know how much Microsoft have put into Bing, but certainly billions.)
Yes, exactly! And it’s not just what they poured into actually developing/providing Bing, it’s the mountains of cash they burned purchasing some actual market share (i.e. to fool/default people into using Bing). Personally, I was always astonished by their claims Bing was actually BETTER than Google search?! Cos this was never a Coke vs. Pepsi challenge: Every time I got fooled into using Bing, visually it looked much the same, but almost immediately I would think ‘WTF is wrong with these search results?!’, and then I’d notice…