Image Shown: Shares of Alphabet Inc Class C, a top weighted holding in our Best Ideas Newsletter portfolio, continued their upward climb in 2019 and maintained their stellar trajectory.
By Callum Turcan
On February 3, Alphabet (GOOG) (GOOGL) reported fourth quarter and full year earnings for 2019. The firm’s bottom-line beat consensus estimates, but Alphabet’s top-line miss sent shares modestly lower the next day on Tuesday, February 4. We continue to like Alphabet’s Class C shares as a top weighted holding in our Best Ideas Newsletter portfolio with our fair value estimate sitting at $1,440 per share of GOOG (under our base case scenario) and the top end of our fair value estimate range sitting at $1,800 per share of GOOG (under our optimistic case scenario that’s still deemed reasonable, in our view).
Financial Overview
In 2019, Alphabet’s GAAP revenues grew 18% year-over-year to $161.9 billion on the back of strong performance at its ‘Google Search & Other’ (sales were up 15%), ‘YouTube ads’ (sales were up 36%), and ‘Google Cloud’ (sales were up 53%) segments. Alphabet’s GAAP operating income jumped 24% to $34.2 billion which saw its GAAP operating margin climb higher by over 100 basis points year-over-year. By limiting GAAP operating expense growth to just 17% year-over-year– keeping in mind Alphabet is investing aggressively in growing its various business segments while experiencing material top-line growth–the company was able to realize meaningful margin expansion.
Alphabet’s net operating cash flow came in at $54.5 billion in 2019, up 14% year-over-year, while its capital expenditures shrunk by 6% year-over-year, coming in at $23.5 billion. That allowed for $31.0 billion in free cash flow, up 36% year-over-year. We continue to be really impressed with Alphabet’s cash flow profile and view its growth outlook quite favorably. In the graphic below, from our 16-page Stock Report (can be accessed here), we highlight how we view Alphabet’s free cash flow growth trajectory in the medium-term.
Image Shown: Our discounted cash flow models forecast material free cash flow growth at Alphabet over the coming years, even under the lower band of our forecast range.
While Alphabet does not pay out a common dividend at this time, the firm spent $18.4 billion repurchasing its common stock in 2019. That was roughly double what Alphabet spent on share buybacks in 2018, highlighting management’s growing focus on rewarding shareholders. Given that Alphabet traded well below our fair value estimate for most of 2019, we appreciate management stepping up share buybacks given that’s a good use of shareholder capital.
At the end of 2019, Alphabet was sitting on $119.7 billion in cash, cash equivalents, and marketable securities on top of $13.1 billion in non-marketable securities. Excluding non-marketable securities and keeping Alphabet’s $4.5 billion long-term debt load in mind (the firm did not have any short-term debt on the books as of the end of 2019), the firm’s $115.1 billion net cash position continues to be the envy of the corporate world.
Strategic Shift Commentary
Last December there was a leadership change at the top, which saw co-founder Larry Page step down as CEO of Alphabet, handing the reins over to Sundar Pichai who was already running Google (operating under the Alphabet umbrella). We have yet to really see how this will change Alphabet’s capital allocation strategy. Going forward, we will be closely monitoring any changes in Alphabet’s overall strategy as it relates to capital allocation, operating expense growth, and potentially the initiation of a common dividend program farther out.
CEO Sundar Pichai started off Alphabet’s latest quarterly conference call mentioning that the company “will continue to take a long term view” as it relates to making major investments in healthcare (Verily, Calico, Google Cloud), autonomous driving (Waymo), and other areas. However, Mr. Pichai also noted that Alphabet would balance out the need to make those investments with the need to make a nice return on investment. Here’s what he had to say during Alphabet’s latest quarterly conference call (emphasis added):
“Google Cloud works with hospitals and healthcare providers to securely manage their patients’ data – data that is much more secure in the Cloud than in paper records or on premises. Our AI teams at Google also work with partners to apply AI to help them and their patients — whether it’s developing better health systems, or helping with the diagnosis and detection of disease. Among their broader efforts, our Other Bets Verily and Calico are also partnering with industry leaders, to use AI and cloud technologies to improve clinical trials, research and drug development.
Our thesis has always been to apply these deep computer science capabilities across Google and our Other Bets to grow and develop into new areas. The Alphabet structure allows us to have a portfolio of different businesses with different time horizons, without trying to stretch a single management team across different areas. We will continue to take a long term view, managing the portfolio with the discipline and rigor needed to deliver long-term returns.
Many of our Other Bets are getting to the stage where it now makes sense for them to partner closely with other players and investors in the industry.Waymo’s technological leadership is widely reported – its cars have driven 20 million miles across more than 25 U.S. cities. Waymo is now serving over 1,500 monthly active riders in Metro Phoenix and continues scaling fully driverless by matching early riders with driverless vehicles and charging for these rides.”
We’ve noted in the past that due to Alphabet’s ‘Other Bets’ segment, which historically has posted large operating losses on marginal revenues relatively speaking, the company was more profitable than first appearances suggest. Keeping that in mind, where Mr. Pichai notes that the firm is considering pushing more of its Other Bets ventures into the early stages of commercialization, it appears Alphabet could be at the very early stages of rationalizing some of its long-term bets (or at least heading in that direction to some degree).
That doesn’t necessarily mean that management is contemplating large cuts to Alphabet’s ‘Others Bets’ segment, but that going forward, the company is going to place a greater emphasis on ventures with a line of sight on generating meaningful sales (and eventually, profits) as compared to ventures that could arguably be described as vanity projects.
Anti-Trust Commentary
Here at Valuentum, we don’t buy into the notion that the anti-trust and regulatory hurdles at-large would ruin Alphabet’s ability to generate free cash flows, far from it. In fact, we think that if there were to be a serious risk of Alphabet getting broken up into several different pieces due to anti-trust actions taken by the US (which is quite unlikely at this stage), the market would re-rate shares of Alphabet under a sum-of-the-parts basis which could see shares of GOOG trade materially higher given the strength of its digital advertising businesses.
Additionally, Waymo (its autonomous driving subsidiary) is considered the leader in the semi-autonomous/fully-autonomous driving space and would likely fetch a nice valuation as well even though the segment doesn’t appear profitable at this stage. Most importantly, digital advertising is a high-margin business supported by secular growth tailwinds, making the free cash flow outlook for Alphabet’s Google Search and YouTube operations very promising.
Maybe this seems a tad counterintuitive at first, but again, please note that Alphabet’s Other Bets segment lost $2.0 billion in the fourth quarter of 2019 alone on just $0.2 billion in sales. For the full year, Alphabet’s Other Bets segment posted an operating loss of $4.8 billion on $0.7 billion in sales. As a smaller entity, we would likely see Alphabet cut a lot of spending on its long-term bets under a break-up scenario (Waymo would still likely see a significant amount of investment) given that only a behemoth like Alphabet could lose almost $5 billion per year and not break a sweat.
Alphabet still intends on investing in the long-term, but realistically, anti-trust regulations would force some big structural changes and that could see the firm become a lot more profitable “overnight” simply by focusing on its bread-and-butter (digital advertising).
Concluding Thoughts
We continue to like Alphabet as a top weighted holding in our Best Ideas Newsletter portfolio and see the firm’s outlook as bright under multiple scenarios (with or without anti-trust action). Alphabet reported strong results for the full-year and its enormous net cash balance creates a lot of opportunities in terms of share buybacks and potentially initiating a common dividend sometime in the future.
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Related: GOOG, GOOGL
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Callum Turcan does not own shares in any of the securities mentioned above. Microsoft Corporation (MSFT) and Oracle Corporation (ORCL) are both included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Alphabet Inc (GOOG) Class C shares are included in Valuentum’s simulated Best Ideas Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.