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Investment Conclusion
Alphabet (NASDAQ:GOOG) is an excellent business in terms of generating net income and free cash flows. However, with respect to long-term growth potential, the company is far from attractive. Over the last nine-months ended September 2022, GOOG generated ~$207 billion in revenues, ~$46.3 billion in net income, and ~$44 billion in free cash flows, with a profit margin of 22.4%. Clearly, GOOGL is a cash cow. However, the current prosperity is based on advertisement revenues (80% of total sales) from businesses that are on track to declining growth, or generating moderate growth, over the long term.
Every day, Google Search is engaged in a losing battle with competitors slowly but surely capturing market share. In addition, although the YouTube business appears promising as a secular growth driver, given the lack of initiatives to further monetize the platform, it appears that any expansion in revenues, will be driven by external forces, indicating moderate growth. Further, Alphabet’s Chrome Browser is losing market share in the U.S. and globally in regard to desktop computing. Moreover, Google Cloud which was launched 14 years ago, has 10% market share, solidly behind a key competitor that debuted two years later. Furthermore, the Other Bets segment, comprised of smaller companies, that remain unprofitable, is in our opinion, a loss leader, designed to accumulate customer data, to further personalize GOOG’s advertisements (to expand advertising revenues). Not a single one among these enterprises, demonstrates the potential to evolve into a strong stand-alone business, generating substantial profits.
Nevertheless, Google Search that accounted for 72.4% of advertising revenues, over the prior three quarters, is so widely entrenched across the globe, that Alphabet as a business has the ability to absorb the implications of unfavorable market forces for a while, and continue to generate sufficiently large amounts of profits and free cash flows. That appears likely the justification for management inaction to enforce policies that would ensure significant long-term growth. Based on their public commentary, it appears that GOOGL’s leadership believes the company is on track. Therefore, we do not expect any dramatic shifts in the corporation’s long-term growth strategy.
We are initiating on Alphabet with a Buy Rating and a 1-year Price Target of $108/share, based on inputs to our 10-year Discounted Cash Flow model, which includes, a perpetual growth rate driven terminal value.
Investment Thesis
Alphabet, as Google, was founded in 1998 in Menlo Park, California. The company’s present headquarters are in Mountain View, California. GOOG has research and development facilities and data centers located in North America, Europe, South America, and Asia.
The firm operates in two segments, Google and Other Bets. GOOGL’s revenues are derived from: advertising sales generated by Google Search, YouTube, and Google Network; Google Other; Google Cloud; and Other Bets. Over nine months ended September, 2022, Google Search accounted for 58% of total revenues, YouTube for 10.3%, Google Network for 11.8%, total advertising for 80%, Google other for 9.8%, Google Services total for 89.8%, Google Cloud for 9.2%, and Other Bets for <1-2%.
The predominant issue surrounding Alphabet is whether the firm’s current financial challenges are systemic? The secondary issue garnering investor interest is what is GOOG’s long-term financial outlook? We answer the questions below.
GOOG’s Best Days Appear Behind It
We believe the company’s underwhelming performance over the previous three quarters is systemic. It is based on weakness in segments of GOOG’s major businesses.
To illustrate, in the U.S., Google Search’s market share is declining on an overall basis and with respect to desktop and mobile. Globally, although on a comprehensive basis and in terms of mobile, Google Search’s trends are on an uptick, the platform’s market share is contracting in regard to desktop.
The key beneficiary of Google Search’s U.S. market share loss is Microsoft (MSFT), as its Bing is the default search engine on machines that operate on its Windows, the world’s second most utilized operating system. In that regard, it is noteworthy that from April 2009 to January 2022, the percentage of U.S. web searches performed on Google sites decreased to 61.4% from 64.2%, while that associated with Microsoft sites increased to 26.8% from 8.2%. Although, some fraction of Google Search’s U.S. web search was likely rerouted to mobile, importantly, mobile search in the region peaked at 64% in C2Q2020, had decelerated to 63% by C4Q2021, and has been steady since. In addition, on a world-wide basis, from January 2010 through October 2022, Google Search’s desktop share has declined to 83.8% from 90.8%, and that related to Bing has expanded to 9.89% from 3.4%.
Further, that multiple larger countries now have indigenous search engines, which their citizens apparently prefer, with 85% of people in China utilizing Baidu, and 59% of the Russian population conducting web searches on Yandex, likely supported Google Search’s loss of global desktop market share.
Nevertheless, Google Search will likely continue to dominate global search for a while due to strategies the firm has implemented to preserve a significant fraction of the search engine’s market share. These include the acquisition of Android, which positions Alphabet to impose Google Search on a majority of smart phones. In addition, the corporation developed the Chrome browser (the world’s most utilized browser), which has Google Search as the default search engine. Further, GOOGL agreed to pay Apple (AAPL) $10 billion/year to enforce Google Search as the default search engine on Apple products. Moreover, barriers to entry in the search engine business are high, not only because it expensive and difficult to get started, but also due to the large looming presence of Google Search, whose first mover advantage is onerous.
Therefore, although, smaller search engine companies are developing niche presences, with DuckDuckGo and Neeva that do not collect or share personal information on their users, and Ecosia and Ekoru that invest some percentage of their revenues on sustainability initiatives, the competition they present is hardly daunting, as yet. Microsoft, which similar to Alphabet is in the process of increasingly powering its search engine with artificial intelligence (AI), could represent more formidable competition.
However, these market forces combined with technological shifts (and Google Search’s own inadequacies, for example, pushing to the top, results from: its own products as well as those from its partners and big advertisers, and those aligned with its world view), such as voice operated virtual assistants like Alexa and Siri, and product searches performed on: Amazon (AMZN) and Meta (META), as well as on dedicated websites such as Kayak, could slowly but surely accelerate the decline in Google Search’s dominance.
In addition, although, clearly GOOG’s content sharing social media platform YouTube is impressive, audience growth has declined between 2017 and 2021, decreasing to 4.9% from 9.4%. Although, advertising revenue growth associated with the organization is a function of multiple factors, predominantly dependent on advertiser’s assessment of the impact of the economic environment on potential sales of their products and services, growth in the percentage of viewers is important, as advertising revenues are dependent on the number of clicks and views of five second programming. Therefore, in an absence of increased focus on monetizing strategies, we expect YouTube’s secular growth to be moderate and driven by external forces. However, considering that the more time customers spend in the Google environment, the more personal data Alphabet captures on them, YouTube with the highest average duration/visit on the internet, provides the company the opportunity to further personalize advertisements and expand its advertising revenues.
Further, its browser Chrome has its own growth issues. The service is losing market share in the U.S., which accounts for 47% of GOOGL’s total revenues. To be specific, Chrome usage related to desktop computing in the region continues to decrease. In addition, although Chrome is clearly the preferred browser on a global basis, the usage has peaked and the trend is downwards sloping, in regards to desktops. The key beneficiary of the browser wars appears to be Microsoft’s Edge, particularly in the U.S., where it is capturing market share from Chrome in regard to desktop computing.
Moreover, although Alphabet projects Google Cloud as a long-term growth driver, fundamentals of the business suggest that capturing market share from Amazon’s Amazon Web Service (AWS) and Microsoft’s Azure will be challenging. In that regard, it is notable that AWS derives its edge from the massive scale of its operations, that include the largest global network of data centers and a myriad of constantly expanding services. Azure’s primary advantage is that it is well integrated with the other services that Microsoft provides, including its Windows operating system. Since, a majority of world-wide corporations utilize Windows and additional Microsoft tools and services, it makes sense for them to select Azure as the cloud computing platform.
Given these factors, Google Cloud is viewed as a secondary provider within the cloud computing industry, chosen by competitors of Amazon, and companies that prefer an open system, which is less compatible with Azure. Accordingly, Google Cloud is positioned third in the market with 10% share, behind Azure with 21%, and AWS with 34% in the top spot. For nine months ended September 2022, Google Cloud revenues were ~$18.9 billion, Azure’s were ~$56.7 billion, and AWS came in with ~$58.7 billion. Although, over the prior quarter, Google Cloud’s revenues expanded by 38%, ahead of Azure’s 35% growth, and AWS’s 28%, the law of large numbers explains the difference, considering the significant disparity between the actual revenues of the platform and that of Azure and AWS.
The Other Bets segment of Alphabet is comprised of unprofitable companies which are highly unrelated to each other and to the corporation’s core competency, with the only similarity (between the new firms) being that they are developers of emerging technology.
The arguably largest amongst them is Waymo, an enterprise focused on the development of autonomous driving technology. The firm is currently testing its driverless cars in several cities in the U.S., and has a ride-hailing service that utilizes its Lexus self-driving cars in Phoenix, with plans to expand into Los Angeles, over the near term. In addition, there is Loon that is working on providing internet connectivity in remote and rural areas deploying high-altitude balloons. An additional Other Bets enterprise is Fibre, founded in 2010, which provides broadband internet in roughly six U.S. cities. Calico is focused on research and development of technology that would prevent age-related medical conditions.
These ventures are so dissimilar, so early in their stages of development, and so diverse from the GOOGL’s core competency, that their objectives appear misaligned with business development. Overall, given these factors, we do not consider any of the businesses featured under the Other Bets category as Alphabet’s next leg of long-term growth.
GOOG has cited AI and Google Cloud as secular growth opportunities. In regard to the developing role of AI in Google Search, it is noteworthy that although all of the consumer data the company has access to powers the search engine, it does not necessarily render the platform competitively superior, as it appears unlikely that the technology will possess the ability to accurately predict the contents of the human mind, and given the results that a Google Search currently provides, it appears that AI is not performing optimally. Google Cloud’s potential for generating substantial long-term growth appears doubtful, as we have discussed above. Therefore, we believe that fundamentals do not support significant long-term growth of Alphabet’s business.
Financial Under-Performance Likely Permanent
Considering that we do not anticipate sharp shifts in GOOGL’s long-term business strategy, our thesis predicates that secular financial outcomes will reflect the dynamics of continued market share losses associated with Google Search and the Chrome Browser, moderate growth of the YouTube platform, lackluster expansion in Google Cloud, and persistent profit destruction by the Other Bets segment.
In addition, given that we believe that strong FY2020 and FY2021 financial outcomes were a function of a once in a life-time event, when internet adoption rates expanded exponentially, as folks attempted to mitigate the impact of wide-spread lockdowns due to the pandemic, rather than based on fundamental shifts in underlying business conditions. In that respect, it is noteworthy that although digital advertising declined during the initial phases of the viral outbreak, it rebounded strongly towards C3Q2020 and beyond.
Further, we consider GOOG’s financial results over the previous three quarters as indicative of future performance, particularly considering that the underwhelming results (missed consensus revenues and earnings estimates) were more a reflection of margin erosion due to a significant increase in hiring (advanced by 24% over the recent 12-months), represented in an increase in COGS, R&D, and S&M, as a percent of total revenues, the impact of which cannot be rolled back (as employees have to be compensated), although significant sales shortfall, on a year-over-year basis, was an additional factor. Moreover, even though on the F3Q2022 Earnings Call, management announced pullbacks in hiring and capital expenditures, we believe the effort is insufficient to off-set the permanent increase in spending.
Over nine months ended September 2022: revenues were ~$207 billion, reflecting a growth of 13.4% compared to the same period in FY2021; net income was ~$46.4 billion, reflecting a year-over-year decline of 16.3%, and earnings per share was $3.50 versus $4.08 over nine-months ended September 2021. Specifically, year-over-year growth associated with Google Search was 13.4%, that linked to YouTube was 5.3%, Google Network was 8.5%, Google Advertising total was 11.6%, Google Other was 2%, Google Services was 10.4% , Google Cloud was 38.8%, and Other Bets was 47.2%.
Furthermore, as a percent of sales, cost of revenues increased by 110 bps to 43.9%, R&D spending expanded by 160 bps to 14.1%, S&M advanced by 100 bps to 9.4%, and the tax rate declined by 200 bps to 14.5%. In addition, gross margins decreased by 90 bps to 56.1%, operating margins contracted by 280 bps to 27.4%, and profit margins declined by 770 bps to 22.4%. Moreover, operating income associated with Google Services decreased by 0.6%, that related to Google Cloud by 12.6%, and that linked to Other Bets by 16.2%. At the end of F3Q2022, Alphabet had a cash and cash equivalents balance of ~$22 billion and long-term debt of ~$14.7 billion on its balance sheet.
Clearly, over the prior three quarters, the company’s financial performance weakened on all metrics except revenue growth. Given our thesis that long-term financial results are likely to be broadly consistent with those evidenced year-to-date, we are utilizing the performance as a barometer to develop our valuation for GOOGL.
We utilized 10-year Discounted Cash Flow analysis including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $108/share for GOOG. We assume a normalized 10-year revenue growth rate of 9%, (vs. the nine-months ended September 2022 revenue growth rate of 13.4%). In addition, we derive our net income for 10-years using a net profit margin of 20% (vs. net profit margin of 22.4% during nine-months ended September 2022). Based on our analysis of GOOGL’s historic financial reports, we model normalized 10-year operating cash flows as 30% of revenues/year and straight line 10-year capital expenditure as 12% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 13,353 million to arrive at our 1-year Price Target.
Risks
Anti-Trust Legislation Might Split Up The Company. Multiple governments across the globe would prefer that Alphabet be broken up into several independent companies to reduce conflict of interest between the different segments, and to foster competition. However, we do not believe a split of GOOGL is likely to unfold over the short term. The company’s revenues are predominantly generated by advertising and its various businesses are designed to render the advertisements as effective as possible. That is GOOG’s core competency and the organization will dedicate a substantial fraction of its resources to maintain its business model.
However, investors will benefit if Alphabet were to be broken up into parts, as given that pure-play companies secure premium valuation, the corporation’s stock would rally on any news of an upcoming split of the firm. Whether the sum-of-the-parts would be more profitable than a consolidated GOOGL is arguable, in our judgment.
Bottom Line
Alphabet’s Google is a cash cow, which with its billions of dollars of free cash flow generated every year could fund a company that with good counsel could develop a business as revolutionary as Google Search. That is the wild card surrounding the story. However, GOOG as a company in its present form, has hit a brick wall, in terms of potential runaway long-term growth. It’s all down-hill from here.
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