Although we are now deep into the recovery phase of the COVID downturn, I still remain shocked at just how resilient Google’s parent company Alphabet has proved these past 18 months. I mean, a brief sequential drop in revenue and profit was about as bad as it got in FQ2 2020, and even then California-based Alphabet still managed to mint billions in net income and free cash flow, growing its already huge cash pile in the process.
Its performance since then has been exceptionally strong, both ‘business’ and ‘stock’, with sales and earnings both blasting past pre-COVID levels and the share price following suit. Alphabet has now returned around 29% compounded annually over the past five years, which compares favorably to the Morningstar US Market Total Return Index and peer Facebook, though lags Apple and Microsoft.
My view on Alphabet hasn’t really changed much over the past couple of years. I’m still bullish, even after the big run up, and I do think the current valuation comes with a few mitigating features that makes it cheaper than it may look at first glance. If the company can carry on posting double-digit annualized revenue growth, which I think it can for a while yet, then the stock can continue to generate solid total returns for investors.
Exceptionally Strong Growth
It’s still worth reviewing recent figures even though they are a bit out of date now (the company reports third quarter figures in a couple of weeks). As I said in the introduction, growth has been exceptionally strong since the lull in FQ2 2020, with total revenue up over 55% in the first half of 2021 on a two-year basis (just to strip out the COVID effect). Income from operations was up well over 100% to $35.6b, partly thanks to positive operating leverage.
Pretty much all of Alphabet’s business lines have put in very impressive growth figures recently. Even the more ‘mature’ Google Search and Google Network segments are posting revenue around 45% higher than before the pandemic. Breaking things down a little further, the number of paid clicks grew 25% versus 1H 2020, while the average cost-per-click increased around 16%. Or put another way: strong growth in the number of ‘clicks’ on advertisements with a nice bump in the dollar value per click on top. Obviously that comparable reflects softness in the year-ago period, though the number of paid clicks has reliably registered solid positive growth for years now. Average cost-per-click has generally been falling due to a shift in channel mix toward YouTube ads.
Google Cloud has also maintained strong revenue growth, with 2021 half-yearly sales up another 50% year-on-year. Operating losses in the segment narrowed to $1.6b versus over $3b in the year-ago period. Eventually its cloud business will turn a profit and contribute positively to the bottom line.
Still Drowning In Cash
I spoke before about ‘mitigating features’ that makes the valuation a bit more attractive than it looks on paper. One of those is of course the balance sheet, which is still drowning in surplus cash. Just re-reading my last piece on Alphabet from early 2020, and net cash & marketable securities stood at around $115b back then (call it around $165 on a per-share basis). That has since increased to a little over $120b, growing faster in per-share terms (now around $180 per share) thanks to the cumulative impact of share buybacks. By my count Alphabet has spent north of $50b on stock repurchases since the start of 2020 (with around $43.5b remaining on its current authorization). Anyway, back net cash out of the valuation and the underlying business is trading a bit cheaper than the headline numbers suggest.
The other mitigating features are (1) the high quality underlying business, which is worth a premium anyway in my book, and (2) the other elements of Alphabet that sit outside the core advertising business. Google Cloud has been growing revenues at a high clip and EBIT losses have narrowed, though it still remains unprofitable at the moment. Likewise, the “other bets” segment, which houses moonshots like self-driving cars (Waymo), is also still a drag on earnings-based valuation metrics. EBIT losses attributable to “other bets” totaled $2.5b in the first half of 2021, while Alphabet spent $27.5b, or around 15% of sales, on research & development last year.
Alphabet stock finished the week at around $2,800, equal to around 28x analyst estimates for 2021 earnings per share. The stock has returned around 150% since last coverage.
Incredible returns notwithstanding, I do still think the shares are attractive. The number of paid clicks continued to grow strongly throughout the pandemic, implying the shift to digital advertising is also still going strong. It’s hard to see that reversing anytime soon, even if it does slow down. Advertising in general probably grows in line with global GDP and I don’t see why Google can’t capture a higher rate still. So, even the mature Search business has an okay long-term growth outlook. YouTube Ads should carry on growing at a double-digit clip, with Google Cloud likewise enjoying great prospects as global technology spend carries on increasing in the years ahead. As per recent management comments, recent trends include cyber security, data analytics, a shift to a hybrid workforce (more working from home) and AI, all of which appear great long-term growth avenues.
Most analysts see profit growth slowing a bit in the near term – maybe mid-to-high single-digit EPS growth in 2022 at the high-end. That’s not surprising given we are about to lap the strong post-COVID growth (indeed, management have said as much), though it’s something to bear in mind. Over the medium-term, I’m expecting revenue growth in the 11-12% per annum area and EPS growth to run a bit higher thanks to stock buybacks.
Summing It Up
Based on the above, I think the shares offer a bit of value, and I’m looking for double-digit annualized returns here over the mid-to-long term. In some ways Alphabet stock looks a bit strange. It’s not the easiest market place if you’re looking for high quality blue chips at a decent price (and that’s putting it mildly), yet here we have one the largest players seemingly offering just that. The stock is not without risk – taxation, antitrust measures and a wider market downturn being three that spring to mind – but in the current market I do believe Alphabet is among the best picks in the mega-cap space.
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