Alphabet: GARP Candidate Stock

by The Compound Investor

Google’s parent company Alphabet (GOOG) released its 2018 results recently. The overall figures looked good to me, even though the market’s reaction was more ambivalent. I’ll start with the major plus point: growth is strong, and I think you can make a good case that the stock is trading at a reasonable price (“GARP“) too. 4Q18 revenue increased 22% year-on-year (23% in constant currency terms), and per-share earnings clocked in at $12.77. That was some 17% higher than Wall Street predictions.

As for the market’s mixed response, it seems to be mostly down to the cashflow situation. I mean, Alphabet is spending a heck of a lot on capital expenditure these days. Of the circa $13b it generated in the last three months of 2018, 55% (around $7b) went on purchases of property and equipment. The comparable ratio in 4Q17 was around 42%, and it is a trend that has got some folks spooked. The fact that the company’s operating margin dropped from 24% to 21% over the same period didn’t help either.

Good News

As far as I can see, that is pretty much the extent of the bad news. Good news, however, still appears plentiful. Firstly, we have the growth situation mentioned above. Five years ago Alphabet earned around $18 per share in net profit. Last year, the company reported net profit of $43.70 per share. Analysts expect earnings to reach $55 per share by the end of fiscal 2020, rising to nearly $75 per share by the end of fiscal 2022. Or put another way, the profit juggernaut is expected to chug along quite nicely at a double-digit annual clip.

Secondly, the valuation seems very reasonable. I mean, you could pick up Alphabet shares for around $1,115 each at Friday’s close. That points to a valuation of around 25x prior-year earnings. That sounds pretty reasonable for a solid growth company, but given Alphabet doesn’t pay a dividend or engage in meaningful share repurchases you might think it a tad underwhelming.

This leads us nicely to the third point: the fortress balance sheet. Alphabet had roughly $16.5b in cash & cash equivalents and $92.5b billion in short-term investments at the end of 2018. On the other side of the equation was just $4b worth of total debt. It kind of goes without saying, but that is an absolutely gargantuan position. It means that Alphabet holds roughly $160 per share in the form of net cash and income bearing investments.

Outlook

Two other points to bear in mind here. Firstly, Alphabet’s industry is obviously somewhat volatile in terms of both of regulation/legislation and business disruption. Having a circa $120b war chest ready to face those sorts of challenges is a good thing in itself.

Secondly, it makes the valuation look quite a bit more expensive than it really is. Taking the net cash balance away from the stock price leaves a “debt adjusted” P/E ratio under 20x last year’s earnings. Needless to say, that is rather more attractive than the 25x multiple I quoted earlier. Overall, I’d say it makes Alphabet a solid GARP stock given its realistic shot of posting double-digit annual earnings growth over the next several years.

Note

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