The case against Alhpanet has low prices
- Down 28% this year, GOOG looks like a clear buying opportunity
- But considering the external dynamics, the case is not so simple.
- In the long run, the action will be fine. But GOOG is not the slam dunk it seems now
At first glance, there appears to be an absolutely strong case to buy Alphabet (NASDAQ: ) (BVMF: ). The share price of one of the best companies in the world has fallen by 28% this year, and the decline can be considered a significant overreaction of a nervous market.
After all, GOOG looks extremely cheap right now. Repurchasing about $18 per share in cash on the balance sheet (net of debt), the stock trades for less than 17 times earnings per share of $5.13. But even that understates the case.
Alphabet is not just Google. It also includes Google Cloud and a group of companies known as “Other Bets”. The latter group primarily includes self-driving startup Waymo, along with Verily, a health research organization.
Google Cloud and other bets have value, but are currently losing money. The core business — known as “Google Services,” including search, YouTube and Android — is printing money. Over the past four quarters, Google’s services generated $96 billion in operating revenue.
At a tax rate of 16.2% (Alphabet’s 2020 and 2021 tax rate), that’s $80 billion in net income, or more than $6 per share. Looking at just the core business and tracking net cash, Alphabet stock trades for about 13 times earnings. And that number doesn’t include Waymo, Verily and other investments, all of which have real value despite currently being unprofitable.
If Alphabet were just Google Services, the bulls would argue that there’s no way the market can value this business at just 13 times earnings. But in fact, this argument may be incorrect.
Margin risk for Google
In 2018, Google Services generated $43.1 billion in operating income, or 33.0% of its revenue. In 2021, the operating profit of Google services was $91.9 billion or 38.7% of revenue.
This multi-year effect is impressive. But the question for Alphabet is whether it is sustainable. In 2021, business grew especially: revenues from services increased by 41%, and operating profit increased by 68%.
The year 2021 was perhaps the best possible environment for online advertising. Startups in various industries competed fiercely for keywords. Teladoc Health is among the companies that say Google’s advertising costs are squeezing their own margins.
Consumers were excited. Companies that focused on their e-commerce strategies spent heavily to attract these customers. Google’s services are a great thing, yes, but the performance in 2021 was driven more by a positive external environment than by any specific strategy the company has implemented.
In other words, it certainly looks like Google Services was the so-called “winner of the pandemic”. And it appears that both his earnings and, more importantly, his profit margins were at an all-time high. We’ve already seen a turnaround in the second quarter, with service revenue up just 10% and operating profit up just 2%.
If margins return to pre-pandemic levels, that alone represents an approximately 15% tailwind for earnings growth. If the global economy — and Alphabet makes more than half of its revenue outside the U.S. — stagnates, revenue could also fall.
This risk is why the market prices GOOG stock the way it is. To be sure, the market is not necessarily correct. But there is logic behind this selloff beyond jittery investors simply selling amid rising interest rates and other broader concerns.
Google has to win somewhere else
It is a concern in the core business. Worryingly, the rest of the business didn’t do so well.
Alphabet is investing heavily in segments outside of Google services. Over the past four quarters, Google Cloud and other bets have posted losses of approximately $9 billion. But these investments have not yet paid off.
Google Cloud lags far behind Amazon.com and Microsoft in market share. Waymo faces competition from Tesla (NASDAQ: ) (BVMF: ), General Motors Company (NYSE: ) (BVMF: ) and many others. Waymo has made progress, but has yet to announce a significant achievement.
Google’s hardware business, whether it’s smartphones, streaming devices or Nest, hasn’t moved the needle. Project Loon, whose goal was to provide high-speed Internet via balloons, has been discontinued. Google Fiber still has a relatively small footprint.
Even with the cyclical risk to top-line ad revenue, there’s an underlying argument that Alphabet investors are getting the rest of the deal “for free,” or something like that. But until the rest of the business shows it can create material value against a $1.3 trillion market cap, that argument looks a little weak.
To be clear, this does not mean that GOOG is short or that it cannot regain support above $100. And it doesn’t mean that GOOG won’t grow in the long term. This remains a big deal; competition in mainstream search is long over, even though TikTok is threatening the cash cow that is YouTube.
On the contrary, the point is that selling here is not irrational. There are real risks here, and the real possibility that Google’s earnings are at multi-year highs. If that’s the case, Alphabet stock might look cheap now, but it won’t look so cheap a year from now.
Exemption responsibilities: As of this writing, Vince Martin is missing Tesla. He does not hold positions in any of the listed securities.