By Kris Rosemann
Shares of Best Ideas Newsletter portfolio holding Alphabet (GOOG, GOOGL) have caught an updraft after the firm reported a strong second quarter of 2016 after the close July 28. Revenue growth accelerated to 21% from the year-ago period, led by above-average growth in Google websites revenue (+24%) and Google other revenues (+33%). The solid performance in other revenues (up to $2.2 billion) was driven by growth in the Google Cloud Platform, as well as in Google Apps and Google Play.
Alphabet also did well in driving bottom-line expansion through improved operating margins; its non-GAAP operating margin grew to 35% from 34% in the second quarter of 2015. This helped non-GAAP diluted earnings per share jump to $8.42 from $6.99 in the comparable period of 2015, even though the firm’s ‘Other Bets operating loss’ advanced to a loss of $859 million compared to a loss of $660 million in the year-ago period. A key driver in the company’s performance in the quarter was the ongoing transition of consumers and advertisers to mobile from traditional desktop computers. Companies are buying an increasing number of mobile ads on its search engine and other platforms, and user clicks on those ads are growing, both big positives for Alphabet.
Strong bottom-line performance led to strong cash-flow generation in the quarter as nearly 29% growth in net cash provided by operating activities and a reduction in capital expenditures drove free cash flow growth of well over 50% on a year-over-year basis to just under $7 billion in the quarter. Free cash flow came in at an astounding 32.5% of total revenue. Such an impressive ability to turn revenue into free cash flow is what has enabled Alphabet to continue to invest responsibly in supporting its many compelling opportunities while maintaining a fortress-like balance sheet. As of the end of the second quarter of 2016, the firm’s cash, cash equivalents, and marketable securities has grown to nearly $78.5 billion compared to ~$69.8 billion at the same time in 2015, while total debt stands at a mere $5.2 billion as of the end of the quarter.
Though still a very small part of its top line, Alphabet’s ‘Other Bets’ revenue more than doubled in the second quarter of 2016, indicative of the progress the firm is making in expanding its innovative horizon beyond its dominant search engine Google. Revenue in the segment was primarily generated by Nest (smart thermostat), Fiber (high-speed Internet), and Verily (healthcare). These early stage developments will continue to have lumpy financial results, but Alphabet is excited about their long-term potential. We may never truly know everything that is in Alphabet’s pipeline of ideas, and that excites us.
Not many companies can get away with spending excessively on something described as “bets,” but this no-fear, entrepreneurial drive is in part what has fueled Alphabet’s culture of innovation and its fantastic track record of growth thus far. Further, the company is such an impressive free cash flow generator that it can easily afford to invest in such speculative developments while concurrently reinforcing its balance sheet. Alphabet’s free cash flow generating prowess, strong balance sheet, competitive dominance in search, and track record of innovation remain core to our thesis as to why we include its stock in the Best Ideas Newsletter portfolio. Shares continue to have considerable upside potential on the basis of the high end of our fair value range.