Google Continued Growth: Strategic Diversification, R&D Investments

Alphabet Inc. (NASDAQ:GOOGL) has employed a consistent capital return program to shareholders through share buybacks. Additionally, the company has demonstrated a clear strategic focus on diversifying its revenue streams, which has enabled it to minimize its dependence on the performance of its core Google search business. Further to this, the company has identified the cloud computing market as a key area for growth, which is a market that is currently experiencing significant expansion. Given the latter and in combination with strong fundamentals, I believe GOOGL is a buy. Let´s dive into the business.

Business Overview

GOOGL operates a business model that centers around advertising and cloud computing services. GOOGL advertising revenue is generated primarily through Google search engine, YouTube, and Google Networks which amounts to approx. 90% of total revenues. The Google Advertising segment is responsible for the majority of the company’s revenue, as it benefits from a wide user base and the increasing use of digital advertising. The remaining 10% of the revenue is generated through Google Cloud and to a much small extent Other Bets. Google Cloud segment is responsible for the company’s efforts to diversify its revenue streams and is becoming an increasingly important part of its business.

Financial Overview

In terms of financial performance, GOOGL reported trailing twelve months revenues of $282 billion, cash flow from operations of $92.8 billion, and free cash flow of $62.5 billion. These numbers showcase the company’s financial strength and ability to generate cash flow consistently. Google Search has been the primary contributor to GOOGL revenue streams, however, in recent years, YouTube has experienced significant growth and has begun to represent a notable share of overall revenue, approaching 10% (Please refer to table below). It is worth noting that this dynamic aligns with the company’s strategy of diversifying revenue streams. It is important to recognize that while YouTube’s revenue is primarily generated through advertising, it represents a distinct revenue channel.

When it comes to the cloud market, Google Cloud competes with industry leaders Amazon (AMZN) AWS and Microsoft (MSFT) Azure. As per the third quarter of 2022, AWS accounted for 34% of the market, Azure with 21% and Google Cloud at third place with 11% of market share. Despite being a distant third, Google Cloud has been growing rapidly and has been an important contributor to the company’s revenue. The table presented below displays the revenue growth of Google Cloud, as evidenced by the third quarter and prior third quarter periods. As it can be seen the cloud segment has experienced double-digit increases in revenue on a year-over-year basis. Although the segment is still not profitable, it is projected to make a significant contribution to the company’s bottom line in the near future.

To keep up with the competition and maintain its technological edge, the company´s management has been investing heavily in research and development, spending $38 billion during the last twelve months to enhance its technological capabilities and develop new products and services. These massive investments help GOOGL remain a dominant player in the digital advertising and the cloud computing markets. GOOGL fundamentals are truly robust, the company has a fortress in its balance sheet, which is bolstered by $116 billion in cash and cash equivalents, and a somewhat low debt position of $30 billion.

Shareholder Returns

In addition to diversifying revenues and investing in R&D, management has also been focused on returning value to its shareholders. In April 2022, the Board of Directors authorized management to repurchase up to $70 billion of its Class A and Class C shares. This comes as a top up from the previous $50 billion share buyback program, in essence the company has been authorized to repurchase its own common stock to the tune of $120 billion in recent years. Management did not waste time and has spent $81.4 billion in share repurchases during 2020 and 2021. As of September 2022, $43.5 billion remains available under the current buyback program. We can expect management to continue repurchasing stock as GOOGL share price has dropped over 40% since its peak in November 2021.

Key Areas for Growth

One of the priorities and key areas for growth for GOOGL is the global cloud computing market. The market is expected to reach $1.2 trillion by 2027, driven by the increasing adoption of cloud technology across various industries. To take advantage of this growing market, GOOGL has been investing heavily in its infrastructure, security, data management, analytics, and AI. These efforts have helped the company to increase its market share and position itself as a strong player in the global cloud market, currently holding the third largest position with around 11% market share. Based on the assumption that Google Cloud is able to maintain a market share of approximately 8% in the global cloud market, which is projected to reach a total size of $1.2 trillion, it is possible that the segment could generate revenues in the range of $100 billion in the future. It is important to note that the previous projection is a hypothetical scenario and should be considered as such. It is based on a number of assumptions, including market conditions and the company’s performance.

Another key area for growth for GOOGL is the digital advertising market. Digital ad spend is expected to reach $1 trillion by 2027 (Please refer to graph below), driven by the increasing use of digital advertising. To take advantage of this growing market, GOOGL has been focusing on its core business of online advertising, mainly through its Google Search engine, Google Network and YouTube which has been growing rapidly. For reference YouTube revenue grew from $15.1 billion in 2019 to $28.8 billion in 2021. A third key area for growth is the artificial intelligence market. The market is expected to reach $400 billion by 2027.

I will not discuss “Other Bets” in this article as it still has ways to go and has very little impact on the company financials.

Valuation

GOOGL has experienced a significant decline in market valuation of over 40% from its peak very close to $2 trillion on November 2021 to its current market valuation of $1.2 trillion. This represents a multiple of 12.4x cash flow from operations and 4x sales. Despite this decline in value, the company’s long-term growth prospects remain robust, given its potential to capture a significant share of the growing cloud computing, artificial intelligence, and digital advertising markets. These markets present a significant opportunity for GOOGL to continue its growth in the future.

For the valuation of the company, I have used the market multiple method, using future forecasted earnings to a 18x multiple. I am using this method because the company is expected to continue repurchasing shares from the open market in the coming years. As mentioned above, during 2020 and 2021, management has spent over $80 billion in share buybacks, further to this the company still has over $40 billion available in the recently approve $70 billion share buyback program. The ongoing share buyback activity is expected to have a significant impact on EPS.

I have obtained the analysts’ revenues forecast from Seeking Alpha data and have applied net profit margin of 22%, which is below the average of the previous 3 years net profit margin of 21%, 22% and 29.5%, respectively. Given these assumptions, I have applied a multiple of 18x, this multiple is below the company historical price to earnings ratio, which historically has been above 18x. Using this method, I have arrived at a market valuation for GOOGL of $1.7 trillion by 2026.

Risks

Dependence on advertising Revenues: GOOGL generates a significant portion of its revenues from advertising. This is why it is important for GOOGL to diversify revenues streams, as its financial performance could be impacted by changes in the digital advertising market. The management team has been actively implementing strategies to diversify revenue streams. Important to note here that management has achieved to diversify a portion of revenues away from Google Search with YouTube and Google Cloud both accounting for 10% of total revenues, respectively.

Regulatory risks: Given GOOGL operates in different geographies, it is subject to several regulations. As it has been seen throughout the years, fines by regulating entities are not a rare occasion. Let´s not forget the dent in the company´s financials by the European Commission fine of $1.7 billion in 2019. Increased regulatory scrutiny can impact GOOGL which could have negative consequences for its financial performance.

Bottom Line

GOOGL has demonstrated a strong track record of diversifying its revenue streams away from Google Search, this has been a significant factor in the company’s ongoing success. Additionally, the company has consistently invested in research and development, which has enabled it to remain competitive within the digital advertising and cloud computing markets. Furthermore, GOOGL ability to generate substantial revenues and free cash flow has enabled it to return value to shareholders through massive share buyback programs. Based on the company’s strong fundamentals and growth prospects in markets where it is already a dominant player, the company is well positioned for continued success in the future.