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Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) is a high-quality company that has seen its shares decline quite a lot in recent months — despite strong results and an undemanding valuation. I do believe that Alphabet is considerably undervalued at current prices, especially once we give the company credit for its not-yet-profitable business units such as Waymo.
In recent months, the tech industry as a whole has come under considerable pressure:
The Nasdaq (QQQ) is down 21% from its 52-week high right now. Reasons for that include pressures from rising interest rates and weak results from some of the pandemic plays, such as Netflix (NFLX) or Amazon (AMZN).
Somewhat surprisingly, Alphabet is down even more than the broad tech market, as it currently trades 22% below its 52-week high. I do not think that this is reasonable, as there are several reasons to believe that Alphabet should perform better than the broad tech market in the current environment.
First, its strong current profitability means that rising discount rates (due to rising interest rates) should not have an impact on GOOG that is comparable to what the impact should be for not-yet-profitable tech stocks such as Teladoc (TDOC). Rising interest rates also should actually lift Alphabet’s current profits, as the company holds a sizeable net cash position — more on that later.
Alphabet also did, unlike many other tech stocks, not report weak results in its most recent quarterly update. Instead, the company continued to grow its top line by more than 20%, which compares very favorably to the growth delivered by Amazon (8%) — despite the fact that Amazon is trading at a way higher valuation and has significantly weaker fundamentals overall.
Alphabet’s first-quarter earnings featured a revenue beat, as the company’s top-line result of $68 billion was slightly stronger than expected, rising by 23% year over year. When we consider the pandemic tailwinds during the previous year’s quarter and Alphabet’s already massive size, with annual revenue approaching the $300 billion range, growth of more than 20% is an outstanding feat.
Alphabet also was able to grow its profits considerably, which further distinguishes GOOG from companies such as Amazon that saw their profits come under pressure from rising costs.
GOOG’s earnings results
Alphabet’s operating income was up by $3.6 billion during the first quarter, compared to the previous year’s quarter. If the company keeps that up for the remainder of the year, its operating profit will rise by a hefty $14+ billion during 2022 alone. It should be noted that net income was down year over year, but that was due to an abnormally positive other income/expense position during the previous year’s period. I do not believe that net income is the best metric to look at in this case, as it is distorted by one-time items that are not backed out when looking at GAAP numbers. Instead, operating income tells a cleaner story about where the company is headed. With GOOG keeping its margins stable at a very compelling 30% during the quarter, it clearly is able to control costs and combat inflation effectively, unlike some of its mega-cap tech peers such as Amazon.
Overall, Alphabet’s recent results look strong to me, as the company delivers where it counts — business growth, revenue growth, and keeping its operating margins strong. The fact that GAAP net income was down year over year due to one-time items in the previous year’s quarter is, I believe, not reflective of the company’s underlying success.
Some tech stocks are clearly feeling a pandemic hangover, as work-from-home or stay-at-home headwinds fade. Netflix, for example, benefitted quite a lot from the environment over the last two years when everyone was looking for at-home entertainment options. Now, with everyone looking forward to going out more as the pandemic is fading, Netflix is having trouble growing its business. That clearly is not the case for Alphabet, which continues to deliver compelling growth. If the company can do that even despite tough pandemic comparables, there is little reason to believe that the growth story will end in the foreseeable future, I believe.
The law of large numbers dictates that growth will inevitably slow down at some point, as 20%+ growth forever is a mathematical impossibility. But even if growth slows down gradually from the current level, Alphabet should be able to deliver solid business growth for many years. In fact, even if growth was just half as high as it is today, at 11%-12% a year, that would still make for a compelling investment as long as margins remain strong — and as we have seen in the most recent results, margins are not a concern.
Analysts are currently predicting revenue growth of 14%-19% over the next couple of years, according to Seeking Alpha’s data. That seems like a realistic estimate to me, considering the strong market position and digitalization tailwinds on the one hand, and headwinds from baseline effects on the other hand. If growth comes in at 15% a year on average, which would be on the conservative side relative to what analysts are predicting, and which does not yet factor in GOOG’s history of beating consensus estimates, total revenue could grow to around $450 billion by the end of 2025, which would make Alphabet one of the largest companies in the world in terms of revenue generation.
Even more importantly, Alphabet’s earnings per share growth outlook is compelling as well. If operating margins remain stable, as they have over the last year, operating profits would climb by 15% a year from the current level in the scenario laid out above. When we assume that one-time items balance out over time, net income would climb by 15% a year as well. Earnings per share should rise somewhat faster, however, due to the impact of share repurchases that will lead to each share’s portion of the pie growing larger over time.
In the above chart, we see GOOG’s buyback spending and its share count. Shares outstanding have been declining in recent years, as the company returns a growing portion of its strong free cash flows to the company’s owners. Over the last year, Alphabet has bought back $52 billion worth of shares. If the company keeps that up with shares trading for just $2,300, the company could buy back a pretty hefty 20+ million shares each year, or more than 3% of the company. Since Alphabet has generated free cash flows of $69 billion over the last year, the company could easily accelerate its buybacks further if management wants to do that. The steady ramp-up in buybacks over the last three years, which can be seen in the above chart, might indicate that buybacks could indeed rise further going forward. But even if GOOG’s share count were to decline by just 2%-3% a year going forward, that would add meaningfully to Alphabet’s earnings per share over time. Between revenue growth and buybacks, a high-teens earnings per share growth rate thus seems quite achievable, I believe.
15%-20% earnings per share growth doesn’t make GOOG a buy automatically, as valuations have to be considered as well. Luckily, Alphabet does look very good on that front as well. The company trades for just 20.7x this year’s expected net profit today, which seems like an unreasonably low valuation, considering the quality, moat, track record, and business growth outlook. That doesn’t tell the whole story yet, however. Alphabet has a net cash position of around $120 billion on its balance sheet today. Investors are thus not really paying $2,300 per share for the profits the company generates — instead, investors are paying around $2,100 per share once we net out the company’s cash and debt. The net cash-adjusted earnings multiple is thus even lower, at around 19 at current prices.
We can (and should) make further adjustments to that, I believe. Alphabet’s “other bets” businesses are not profitable and generate a loss of around $4 billion to $5 billion a year right now. Still, those businesses have value, I believe. Waymo, for example, is one of the leading autonomous driving companies, and its value is likely in the dozens of billions of dollars. When we go by the implied value of Tesla’s (TSLA) self-driving business, Waymo could even be worth north of $100 billion. When we only look at the bottom line result of Alphabet’s other bets businesses, their real value is thus not captured. If these companies were spun off, they would create value for Alphabet’s owners, as they would now be direct shareholders in Waymo, Verily Life Sciences, and so on. At the same time, the losses these companies generate today would no longer be recorded at Alphabet, which would result in a higher operating profit and higher earnings per share for GOOG. When we just back out the losses generated by these units without ascribing any further value to them, GOOG’s other bets-adjusted earnings per share would be around $120. The earnings multiple, once we adjust for Alphabet’s net cash and the other bets businesses, would then be around 18. To me, that seems like a way too low valuation for GOOG’s core business that is still delivering strong growth and that sports excellent fundamentals (margins, return on capital employed, etc.).
Another way to look at Alphabet’s valuation is the enterprise value to EBITDA ratio:
Alphabet’s EV/EBITDA ratio looks quite low in absolute terms, at less than 12. It also looks pretty low compared to other large-cap tech stocks, such as Apple (AAPL) or Amazon — and even compared to how large-cap consumer staples stocks are valued. When we consider that Alphabet has the best revenue growth estimate in the above group by far, despite trading at the lowest valuation, it seems to be pretty clear that there is a major disconnect here.
Many tech stocks rightfully sold off in recent months, as they were either way too expensive, or as they delivered bad results. But neither holds true for GOOG. It was not especially expensive a couple of months ago and looks outright cheap today, once we adjust for factors such as its huge cash hoard. And yet, it continues to deliver compelling results, even against tough pandemic comparables — unlike way more expensive companies such as Amazon. To me, the current valuation does not make sense — Alphabet looks like a way undervalued tech stock here, especially when we consider its strong quality, fortress balance sheet, and the hidden value of business units such as Waymo.
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Disclosure: I/we have a beneficial long position in the shares of GOOG, AMZN 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.