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Alphabet: This Is A $3,000 Stock (NASDAQ:GOOG)

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Summary

Alphabet ((NASDAQ:GOOG)(NASDAQ:GOOGL)) is one high-quality business, but the stock hasn’t been able to escape the brutal tech selloff thus far this year. Despite sentiment being incredibly bearish under current macro narratives (inflation, stagflation, oil prices, rate hikes, recession, 10-year yields, war, and China), Alphabet remains a highly profitable and free cash flow generative company that will likely continue to reward investors with strong earnings and buybacks. In my view, the stock’s selloff is overdone, and investors who capture this opportunity should see shares revisiting $3,000 when markets get over all the macro noises.

Why is Alphabet a $3,000 stock?

Before we discuss valuation, I think it’s important to understand why Alphabet will continue to be a great business while a number of companies of similar caliber are seeing trouble in a post-COVID environment marred by inflation. Many investors tend to think of Google along with other FAANG stocks as no-brainer buys during market selloffs, but negative price reactions of companies such as Meta (FB), Netflix (NFLX), and Amazon (AMZN) have given investors a painful lesson that corporate fundamentals are dynamic rather than static.

For example, Meta is grappling with Apple’s iOS privacy changes and burning through billions of cash in building the metaverse. Netflix is losing subscribers and trying to make you pay more for sharing your brother’s password. Amazon has too much warehouse capacity as e-commerce demand slows and margins have been crushed thanks to inflation.

So what makes Google different from these names? The simple answer is that Alphabet’s core business of search advertising is in a highly enviable position as Google is literally the gateway of the Internet (a modern-day utility).

Among billions of Internet users who spend hours on their PCs and smartphones every day, Google plays the indispensable role of collecting, filtering, and delivering relevant information in response to every search request on Google.com and YouTube. There are trillions of data points on the World Wide Web, so how can a search engine go through all of them and figure out exactly what everyone is looking for? This is the billion-dollar problem that Google has solved by building a massive search index (or library) that no other rival can match.

To understand users’ implicit and explicit needs, a search engine must have a competent artificial intelligence system that provides the best results based on the inquirer’s history and personal preferences. Google invests not just in software and algorithms (Multitask Unified Model or MUM), but also in specialized chips that allow faster computation at scale with its own data centers. The integration between software and hardware is what gives Google an undeniable edge in search and over 90% market share.

What about Apple’s iOS updates? Search advertising belongs to the bottom part of the marketing funnel, therefore, conversions usually take place within Google’s own properties such as Chrome. This puts Google in a safe position from Apple’s privacy policy that cuts off the signals sent to advertisers when users jump from one app to another. That said, Google has discussed signal loss in direct response ads on YouTube, but the overall impact has been minimal.

Because search functions essentially as the “last mile delivery” in the consumer journey, advertisers are least likely to cut budgets that are conversion-based. This is also why Amazon has a robust advertising business as every dollar spent is highly likely to generate a customer purchase. Overall, I see Google as a better play in digital advertising than Meta (see why).

And what about inflation? It’s true that Alphabet is hiring more engineers and great talents are more expensive than ever. But Google’s operations are much less impacted by high energy prices compared to businesses whose input costs primarily consist of commodities. More importantly, Alphabet has 30% operating margin which provides a cushion against higher costs. This is very different from Amazon’s e-commerce business that makes roughly 2% operating margin in a good year like 2020 when demand skyrocketed.

Bottom line, Google doesn’t have a user problem like Netflix, a business problem like Meta, or a margin problem like Amazon. If I must find one, it’d be a regulatory problem as the company has a history of paying hefty fines to regulators for its monopolistic power ($9.5 billion in total to the European Commission from 2017 to 2019). Then again, it’s important to note that consumers are never forced to go on Google.com when they search for something. There are plenty of choices from Microsoft Bing to DuckDuckGo, but Google is simply better.

Okay, so why is Alphabet a $3,000 stock?

Alphabet is a collection of 3 business segments (Google Services, Google Cloud, and Other Bets) and thus can be valued based on a sum-of-the-parts (SOTP) approach. The Google Services segment, consisting of Google Search (Google.com, Gmail, and Google Maps), YouTube, Google Network, Google Play, and Hardware (Fitbit, Pixel, etc.), is the most important business unit that makes up over 90% of Alphabet’s revenue and >100% of company operating income as other segments are deeply in the red.

Google Services revenue grew 41% in 2021 and Street estimates of 16% and 14% growth in 2022 and 2023 seem reasonable as growth will obviously moderate going forward. As Alphabet ramps up hiring in 2022, I’d expect expenses to pick up and assume operating margin of ~35% from 39% in 2021. Suppose effective tax rates remain in line with 2021 at 16%, Google Services could generate net income of ~$80 billion and ~$91 billion or diluted EPS of $120 and $140 in 2022 and 2023, respectively (see below). Applying a target multiple of 23x (vs. 3-yr avg. of 29x), this comes down to $2,765/$3,211 value per share in 2022/23.

Next we have Google Cloud, a number three in the global IaaS and PaaS market that will likely reach a $400 billion TAM by 2025. Google Cloud is the fastest-growing business unit that saw revenue grew 47% in 2021 and 44% in 1Q22. Unlike Amazon’s AWS and Microsoft’s (MSFT) Azure that both generate over 30% operating margins, Google Cloud is yet to turn a profit until 2023 in an optimistic scenario. From a valuation perspective, I think it’s worth staying on the conservative end by assuming a P/S multiple of just 4x (vs. 9x of Microsoft) for $162/$223 value per share in 2022/23.

Last but not least, there’s the “Other Bets” segment that has done nothing but producing losses totaling over $20 billion from 2017 to 2021. In 1Q22, Other Bets unsurprisingly lost over $1 billion as usual. While some analysts would gladly assign a dreamy multiple to this segment for reasons such as Waymo being the key to the future of autonomous driving, I believe today’s markets are no longer interested in long-duration assets and would therefore value Alphabet’s “Other Bets” at $0. Yes, I said it.

Putting everything together, we arrive at an average 2022/23 fair value of $3,181. Given the stock reached an all-time-high of ~$3,000 back in February, I think there’s a reasonable chance for shares to revisit this level when the market works its way through current macro headlines. Further, the stock currently trades at $2,152 ex-cash, implying an undemanding 2022/23 P/E of 20x/16x for long-term investors.

Alphabet SOTP valuation

Company data, Albert Lin

Conclusion

Alphabet was one boring stock in an ultra-low interest environment where any retail investor could buy a company near bankruptcy and triple their “investment” in a week. As investors enter a new monetary environment, however, Alphabet is one great stock to own given the company’s competitive position, enviable margins, and massive buyback power ($70B authorized in April).

Per famous investor Howard Marks, mispricings come from two sources: ignorance and prejudice. Since the market is now (1) dumping tech stocks literally like trash in response to inflation (prejudice) and (2) overlooking the fact that some of the best tech companies are trading at valuations lower than Costco (ignorance), I think there’s never been a better time to pick up shares of Alphabet given the current environment we’re in.


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