Alphabet – More than just ABC

James Buckley


Alphabet - More than just ABC

Alphabet was launched in 2015 as the holding company for Google, the world’s dominant internet search engine. The company is divided into two main divisions, Google Services and Google Cloud. Google Services provides some 90% of group revenues and is made up of the Google search engine, Android the leading mobile phone operating system; YouTube, the world’s most popular video-sharing site and Google Maps, Chrome and many other Google branded internet services. Google Services derives its revenue predominantly from advertising on its search engine, YouTube and other Google platforms. It has benefitted directly from the rapid growth in ecommerce and Google’s unparalleled ability to drive consumers to its advertisers’ e-commerce sites. In the provision of cloud computing services, Google Cloud consistently finishes a distant 3rd place behind Amazon (AWS) and Microsoft (Azure), however it is enjoying rapid growth in this attractive segment.


Alphabet has another smaller loss-making division, Other Bets, which mainly consists of early-stage technology companies, including Waymo, the autonomous ride-hailing service currently operational in Arizona. Alphabet has been active on the mergers and acquisitions front recently and in March 2022 acquired cybersecurity firm, Mandiant, for $5.4bn in an agreed cash offer. As Cybersecurity becomes an increasingly critical sector of the technology industry, Mandiant will be integrated into Google Cloud. In early 2021, Google completed the $2.1bn acquisition of wearable technology maker, Fitbit, which will significantly enhance Google Services offering in wearable devices. Like other technology giants, Alphabet has emerged from the Covid pandemic in a stronger financial and competitive position, as secular trends towards digitisation, ecommerce and remote working all benefit its two main divisions.


In common with the broader technology sector, Alphabet’s share price has had a significant pullback year-to-date and now trade on a forward PE well below their five-year average. On this 2023 price to earnings ratio of under 17X, Google’s very modest premium to the broader US market looks fully justified, with forecast compound annual revenue percentage growth in the mid-teens between 2021 and 2024, a significant premium to the S&P 500.


Current trading:
Alphabet reported Q1 2022 figures in late April. Group revenues grew to $68bn, in line with forecasts, with operating income up 30%. Earnings per share however came in lower than expectations at $24.60 versus $25.60, reflecting a step-up in capital expenditure. Total advertising revenue grew 22% over Q1 2021, also in-line with forecasts, whilst Alphabet announced a further $70bn share buyback, some 5% of current market cap.


Whilst the headline numbers were in-line to slightly ahead of expectations, the shares sold off around 3% in after-hours, mainly due to concerns over slowing growth in ad revenue from YouTube, which grew 14% year over year to $6.8bn, below expectations and down from 25% growth in Q4 2021. This was blamed partially on advertising in Europe suffering pullbacks on the war in Ukraine. Google Search revenues were $39.6bn, a growth of 22% and in line with expectations. The smaller cloud computing division increased revenues 44% to $5.8bn, ahead of expectations, although its operating loss narrowed only slightly to $931m. Group operating margins were maintained at 30%.


Despite generating strong free-cash flow which totalled over $18bn in Q4, Alphabet does not pay a dividend, preferring to return capital to shareholders via share buybacks, which in Q4 totalled $13.5bn. In 2021 Alphabet bought back $50bn of shares, close to 3% of its average market cap during the year. Alphabet currently has over $130bn of cash and cash equivalents on its balance sheet, which should facilitate further buybacks. Alphabet also proposed a 20 for 1 stock split with the results, effective from 15th July for shareholders on the register on 1st July.


Like its US mega-cap peers, Alphabet trades on a premium multiple to the broader S&P 500 index, in the case of Alphabet however this is relatively modest. For the current year their price to earning is just under 20X falling to 17X for 2023, compared to 17X and 16X respectively for the S&P 500. Alphabet is forecast to deliver annual earnings growth in the mid-teens over the next two years however, around double the level of the index, which appears to more than justify the current modest premium valuation. The key driver of increasing levels of marketing spend being diverted into online customer acquisition looks like a secular trend which the company is ideally placed to exploit. Digital commerce penetration in the US is currently just under 20% leaving plenty of future growth for Alphabet to achieve in this channel. Cloud computing is also an industry with attractive growth fundamentals and Google Cloud can continue to make modest inroads into gaining market share here which should lead to profitability by 2024 as margins improve. The small Other Bets division does offer optionality on start-ups like Waymo, as there is little discounted in Alphabet’s valuation for these eventually becoming meaningful contributors to group profitability. We initiate on Alphabet with a $3,300 price target which is 24X 2023 forecast earnings per share, which are likely to prove conservative.


James Buckley is a Senior Equity Research Analyst with Cantor Fitzgerald Ireland.


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