Image Shown: Shares of Alphabet Inc Class C surged higher in after-hours trading on February 2 after the digital advertising giant reported a stellar fourth-quarter 2020 earnings report. We continue to be big fans of the name and include shares of GOOG as a top-weighting holding in the Best Ideas Newsletter portfolio.

By Callum Turcan

On February 2, both Alphabet Inc (GOOG) (GOOGL) and Amazon Inc (AMZN) surprised the market to the upside, but not us. We've been huge fans of large cap growth, big cap tech, and the NASDAQ for some time now. In this note, we cover Alphabet's earnings report. The company is one of our favorite tech giants and a holding in the Best Ideas Newsletter portfolio. We also dig into the recently announced management changes at Amazon. We like Amazon a lot, but we're already very consumer-tech heavy in the newsletter portfolios. We believe large cap growth, big cap tech, and the NASDAQ will remain the most resilient areas under any market pressure caused by price-agnostic trading (indexing, quant, WSB, Robinhood, etc).

Alphabet Remains a Juggernaut

When Alphabet reported earnings for the fourth quarter of 2020 on February 2, it smashed past both consensus top- and bottom-line estimates. The digital advertising giant’s GAAP revenues surged higher by over 23% year-over-year last quarter due primarily to strength at its core digital ad business. Alphabet reported that its ‘Google Cloud’ segment posted 47% year-over-year revenue growth last quarter, which we appreciate as that indicates this operation is finally starting to gain some sustainable traction.

Growth at Google Cloud has been quite strong during the past several quarters as we have covered in the past (link here) and seeing this momentum continue is a very promising sign that Alphabet will eventually become less reliant on its digital advertising businesses (such as Google Search and YouTube). For now, Google Cloud remains the source of only a modest portion of Alphabet’s company-wide revenue and is currently running at an annual operating loss ($5.6 billion in 2020) as the company is scaling up the business (Alphabet only just recently started breaking down the operating profit for its Google Cloud segment).

Alphabet’s GAAP operating income surged 69% year-over-year in the final quarter of 2020, with margin expansion made possible through economies of scale and a reduction in the segment-level operating loss at its ‘Other Bets’ business operating segment. The tech giant has been rationalizing its 'Other Bets' segment, which focuses on long-term opportunities (some of which may not pan out), a process that included Alphabet shutting down its Loon venture, which sought to use balloons to provide Internet to certain regions. We appreciate management limiting the operating losses on this front, which hit $4.8 billion in 2019 and declined to $4.5 billion in 2020. Though a modest year-over-year reduction, that is a nice improvement from the trajectory of widening losses in this area.

In 2020, Alphabet generated $42.8 billion in free cash flow, up from $31.0 billion in 2019, aided by strong net operating cash flow growth and a moderate reduction in its capital expenditures. The firm exited 2020 with $122.8 billion in net cash on hand and no short-term debt on the books, and that is on top of $20.7 billion in non-marketable long-term investments (please note this line-item includes strategic investments). We are huge fans of Alphabet pristine balance sheet and stellar cash flow profile. It spent over $31.1 billion buying back its stock in 2020, which we view as a good use of capital given shares of Alphabet have been trading well below their fair value estimate for some time.

Shares of Alphabet surged higher in after-hours trading on February 2 as shares are steadily converging towards our estimate of intrinsic value, which in our view is significantly above where GOOG is trading as of this writing. There is room for substantial capital appreciation upside, in our view. Our fair value estimate for GOOG sits at $2,493 per share and the top end of our fair value estimate range for GOOG sits at $3,116 per share. We include shares of Alphabet Class C (ticker GOOG) in the Best Ideas Newsletter portfolio as a top-weighted holding and continue to like exposure to the name.

Big Management Changes at Amazon

When Amazon reported fourth quarter earnings for 2020 on February 2, the firm announced that founder and CEO Jeff Bezos was stepping down from the CEO role to become executive chairman by the third quarter of 2021. In our view, Amazon has a deep executive bench full of talent that will be fully capable to step up to the task at hand. The incoming CEO of Amazon, Andy Jassy, is currently CEO of Amazon Web Services (‘AWS’). Mr. Jassy played a key role in growing the cloud computing segment of Amazon over the past decade and a half or so into the market-leading giant AWS is today.

As with Alphabet, Amazon also smashed past consensus top- and bottom-line estimates in the fourth quarter of 2020 as Amazon generated over $100 billion in sales for the first time ever on a quarterly basis. Amazon’s GAAP revenues climbed 44% year-over-year last quarter as its e-commerce and cloud computing operations continued to grow at a brisk pace, which enabled Amazon to grow its GAAP operating income by 77% year-over-year (economies of scale were key). Though we will need to see Amazon’s 10-K filing covering 2020 to know more, it is possible its digital advertising business continued to grow at a brisk pace in 2020, a dynamic that could be supporting its operating margin expansion of late.

Our fair value estimate for Amazon sits at $3,346 per share with the top end of our fair value estimate range sitting at $4,183 per share. Amazon exited 2020 with ~$52.6 billion in net cash with no short-term debt on the books, though Amazon did have $39.8 billion in long-term lease liabilities on the books at the end of last year to be aware of. We are huge fans of Amazon’s pristine balance sheet.

In 2020, Amazon generated $25.9 billion in free cash flow, up from $21.7 billion in 2019; note the firm’s capital expenditures more than doubled during this period. Amazon has a stellar cash flow profile that, when combined with its pristine balance sheet and promising outlook, could eventually facilitate the initiation a common dividend program, something that is more likely under a new management team. Furthermore, Amazon could initiate a share buyback program, and for reference, please note Amazon historically has not spent a material amount buying back its stock.

Concluding Thoughts

Alphabet and Amazon both had to contend with material headwinds due to the coronavirus (‘COVID-19’) pandemic last year, though the underlying strength of their business models and the secular tailwinds supporting the demand outlook for their offerings allowed them to sail through 2020. Looking ahead, demand for cloud computing, digital advertising, and cloud computing offerings should remain strong, which in turn underpins our view that Alphabet and Amazon will continue to grow at a brisk pace going forward. Alphabet remains one of our favorite tech giants.

Related: AMZN, GOOG, GOOGL

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Callum Turcan does not own shares in any of the securities mentioned above. Alphabet Inc Class C (GOOG) 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.