Image Shown: Alphabet Inc Class C shares, GOOG, are up 27% over the past year as of this writing on August 4. We continue to like shares of GOOG as a top-weighted holding in our Best Ideas Newsletter portfolio.

By Callum Turcan

We include Alphabet Inc (GOOG) (GOOGL) Class C shares as a top-weighted holding in the simulated Best Ideas Newsletter portfolio, with shares of GOOG trading near their fair value estimate of $1,436 per share as of this writing. Given its pristine balance sheet, promising long-term growth trajectory and resilient business model, we see room for material capital appreciation upside at Alphabet as the top end of our fair value estimate range sits at $1,795 per share of GOOG.

During the initial phase of the ongoing coronavirus (‘COVID-19’) pandemic, Alphabet remained a free cash flow generating juggernaut. On July 30, the digital advertising giant reported second quarter 2020 earnings that beat consensus estimates on both the top- and bottom-lines, though the year-over-year decline in its quarterly revenue highlighted the headwinds facing Alphabet’s near-term performance due to the pandemic.

Earnings Overview

Alphabet’s GAAP revenues declined 2% year-over-year in the second quarter, though on a constant-currency basis its sales were flat during this period. Last quarter, revenues at its ‘Google Search & other’ and ‘Google Network Members' properties’ segments were down meaningfully year-over-year while revenue at its ‘YouTube ads’ and ‘Google Cloud’ segments were up significantly year-over-year. As it concerns the former two segments, the pandemic prompted many firms large and small to pull back on their digital advertising spend to conserve cash as consumers cut back on spending worldwide (particularly on consumer discretionary items).For reference, please note Alphabet’s YouTube ad revenues represented just a small portion of its total digital advertising revenue and 10% of the firm’s total revenue last quarter.

Pivoting now to YouTube and Google Cloud, Alphabet’s YouTube ad revenues benefited from growing demand for free online education-related offerings (such as Camp YouTube) while Google Cloud benefited from growing demand for its infrastructure and data/analytics offerings. Please note both dynamics are largely due to the pandemic forcing schools to close and many employees to work from home. Additionally, Alphabet’s YouTube ad revenues were supported by the firm rolling out new “features to make video ads more easily shoppable and browsable on YouTube as more businesses are shifting to online to offset physical store closures.”

Management noted that YouTube subscription revenues (for its music and online TV packages) performed well last quarter. Those are classified under ‘Google other’ revenues, and that segment’s revenues were up just under 26% year-over-year last quarter.

Alphabet has been steadily growing its Google Cloud headcount over the past few years, adding both technical and sales roles to support its growth runway in a space it has only managed to take a small amount of market share in. Management cited strong demand from large enterprises as playing a key role in growing Alphabet’s Google Cloud revenues by 43% year-over-year last quarter, which hit $3.0 billion, though that represented just 8% of its total sales during that period. We appreciate Alphabet’s strong Google Cloud performance as that indicates the company has a decent chance of diversifying its revenue streams over time. Here is what management had to say during Alphabet’s latest earnings call (emphasis added):

“In terms of Google Cloud, we are pleased with the traction we're having with large customers who are making multiyear commitments with us. This is reflected in the strength of our backlog, which ended the quarter at $14.8 billion, substantially all of which relates to Google Cloud. This performance is a result of the investments we are making into the cloud go-to-market organization.” --- Ruth Porat, CFO of Alphabet

Company-wide, Alphabet’s GAAP operating income fell by over 30% year-over-year last quarter due to the modest decline in its revenues and a 7% increase in its operating expenses. Alphabet’s headcount rose by over 18% year-over-year during this period. The company noted that its headcount was up by over 4,000 in the second quarter from just the first quarter. We are fine with Alphabet’s growing operating expenses as we remain confident in its long-term growth trajectory, though cost containment efforts may be required if the pandemic lasts for a long period of time (in the event a safe and viable COVID-19 vaccine is not discovered soon).

As an aside, Alphabet’s ‘Other Bets’ segment posted -$1.1 billion (negative $1.1 billion) in operating income last quarter. We would like to stress here that Alphabet is arguably a lot more profitable than it first appears, as the revenue generation from its Other Bets segment is negligible (just over $0.1 billion in the second quarter).

Outlook Update

During Alphabet’s second quarter earnings call, management mentioned that a large portion of the company’s operating expenses were not tied to its (short-term) revenues. That indicates that there is flexibility to trim costs if needed. However, as the company appears optimistic that it will emerge from the pandemic with its growth trajectory intact (on the back of a recovering digital advertising market), Alphabet intends to continue making meaningful investments in its long-term opportunities. Here is what management had to say during Alphabet’s latest earnings call:

“Moving on to profitability. The decline in our Search revenues put significant pressure on profitability, which was further impacted by our ongoing investments for long-term growth. As I discussed last quarter, much of our expense base, both in cost of revenues and OpEx [operating expenses] is not directly correlated with changes in revenues.

For example, although TAC [traffic acquisition costs] and content acquisition costs are obviously tied to revenues, there's a sizable percentage of items in other cost of revenues that are generally less variable in nature, such as depreciation and operations costs of our technical infrastructure as well as for activities like customer support and content review. We remain focused on the user and customer experience, and we'll continue to invest to support our products.

With respect to operating expenses, although we still expect the pace of headcount growth to decelerate somewhat in 2020, we're continuing to hire aggressively in priority areas like cloud. We still expect that headcount additions will be seasonally higher in Q3 as we bring on new graduates. Consistent with prior years, we expect sales and marketing expenses to be more heavily weighted to the back half of the year, in part to support product launches and the holiday season.” --- CFO of Alphabet

Additionally, management noted that “ads revenue gradually improved during the quarter across Search, YouTube and network. However, we believe it is premature to gauge the durability of recent trends, given the obvious uncertainty of the global macro environment.” We appreciate recent improvements in the digital advertising market as Alphabet “remain[s] optimistic about the underlying strength of our business,” though we caution that meaningful short-term headwinds remain.

In the face of the pandemic, Alphabet intends to moderately reduce its capital expenditures in 2020 from 2019 levels. The reduction in capital investment expectations primarily relates to Alphabet slowing down the pace of its office building acquisitions (to support its growing headcount) due to the pandemic and rise of the work-from-home trend. Alphabet intends to continue making meaningful investments in its technical infrastructure in 2020, such as severs at its data centers. Management noted that Alphabet’s technical infrastructure spend would focus more so on servers (with an eye towards optimizing server efficiency as well) than building data centers this year.

Financial Strength Retained

During the first half of 2020, Alphabet generated $14.0 billion in free cash flow ($25.4 billion in net operating cash flow less $11.4 billion in capital expenditures). Those free cash flows covered most of the $15.4 billion spent on share repurchases during this period, though part of those buybacks were funded by Alphabet’s balance sheet. Last quarter, Alphabet’s outstanding diluted share count was 2% lower year-over-year.

At the end of June 2020, Alphabet had $121.1 billion in total cash, cash equivalents, and marketable securities on hand versus just $4.0 billion in long-term debt(and no short-term debt) on the books. Furthermore, Alphabet also had $13.0 billion in non-marketable securities on hand at the end of this period.

We strongly appreciate Alphabet’s enormous $117.1 billion net cash position at the end of the second quarter of 2020 (not including non-marketable securities). Alphabet recently authorized an additional $28.0 billion in share repurchasing authority to buy back Class C common stock, which was announced in its latest earnings report. Those repurchases appear to be a good use of capital given that Alphabet is trading well below the top end of its fair value estimate range as of this writing.

Beyond share buybacks, Alphabet is also investing $4.5 billion in Reliance Industries’ Jio Platforms as part of its bet on India’s digital transformation. Jio Platforms provides 4G telecommunication services to almost 390 million customers, along with a slate of digital apps and services. This represents part of Alphabet’s plan to invest $10.0 billion in India over the coming years to support the country’s digital ambitions, and we like the deal. Facebook Inc (FB), another top-weighted holding in the Best Ideas Newsletter portfolio, recently invested $5.7 billion in Jio Platforms. We are intrigued by the news and will have more to say as Jio Platforms takes advantage of new potential partnerships.

Concluding Thoughts

We continue to like Alphabet Class C shares as a top-weighted holding in our Best Ideas Newsletter, and we see room for significant capital appreciation upside even after the strong year-to-date performance shares of GOOG have put up as of this writing. Alphabet is very well-positioned to ride out the storm, supported by its immense net cash position and high quality free cash flows.

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Computer Hardware Industry – AAPL BB HPQ IBM TDC

Software Industry – ADBE ADSK EBIX INTU MSFT ORCL CRM

Internet Content & Services Industry – GOOG GOOGL BIDU FB JD TCEHY TWTR

Internet Content and Catalog Retail Industry – BABA AMZN BKNG EBAY EXPE GRPN IAC OSTK QRTEA STMP

Related: SPY, QQQ, XLK

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Callum Turcan does not own shares in any of the securities mentioned above. Apple Inc (AAPL), Microsoft Corporation (MSFT), and Oracle Corporation (ORCL) are all included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Alphabet Inc (GOOG) Class C shares, Apple Inc, Facebook Inc (FB), and Microsoft Corporation are all included in Valuentum’s simulated Best Ideas Newsletter portfolio. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. 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.