Alphabet

For now and for the future

Summary

Management

• Founder controlled ~51.5% voting control

  • Larry Page

  • Sergey Brin

• Long term oriented

• CEO promoted by founders from within

Competitive advantage

• Brand moat

• Network Moat

• Google Search

Margin of Safety price point

• Ten Cap entry $61.00

• DCF entry $50 - $80

Current stock price - $111.33 GOOG 0.00%↑

The Company

Alphabet is one of the largest and most successful businesses in existence today.  The company was started by founders Larry and Sergey in 1997.  The business went public in 2004, and since that time has grown exponentially.  In the Early years Sergey and Larry wrote great annual letters to the shareholders explaining the happenings inside google and their thoughts on the future of the business.  Both Founders continually referenced Warren Buffet, and discussed how google was going to be unconventional in its approach to business.  The founders and for the most part the current CEO believe in investing for the long term.

Alphabet is broken down into three segments.  The largest and where the majority of revenue comes from is Google Services.  This business segment primarily generates income from advertising and includes search, Youtube, play store, and other parts of the business. 

The next segment is Google Cloud which is the fastest revenue growing portion of the business and may still be in its infancy in terms of revenue generation.  The businesses that would be in this segment would be Gmail, Calendar, Meet, as well as the actual cloud infrastructure and services business

Lastly, Alphabet lumps their technology investments into other bets.  This segment is typically non earnings accreditive and is classified properly by management as bets.  This would include businesses like Waymo. While we believe there is opportunity in this segment to hit a home run of some, generally speaking these are speculative technology investments that are in their early stages of development.  Only time will tell if they will pay off or not. 

The Story

Google it……. We think that this business has a significant competitive advantage in search and will continue to for the foreseeable future. Think about it and ask yourself how many times have I used Bing, and what did I think of the results I received? Remember ask Jeeves, Yes, But why don’t I use it anymore. Google Search is a behemoth and has an endless amount of data to create targeted adds aimed at one demographic or another which should garner and advantage over other advertising firms.

We believe that Alphabet will continue to utilize their free cashflow to invest in some speculative but helpful and possibly game changing technology that will provide them with their next big revenue generation business.  This is a model that has been discussed by investors like Monish Pabrai when he discussed what he called "Spawners", and has been widely successful for other enterprises around the world.

This Combined with a ~40% annual revenue growth for google cloud will continue to increase the revenue generation power of Alphabet.  Although the cloud segment is not currently Earnings accreditive, it is the type of business that is very "sticky".  Once a business selects the provider for their cloud services, all of their applications, tools, workflows, internal processes, and IT knowledge revolves around the cloud business selected.  It would take a significant amount of resources, lost revenue, and time to switch to a new provider and therefore is likely not to occur.  This is the advantage that IBM had back in the day and it definitely slowed its fall from the top. 

At Black Opal we also took note that the founders continue to own a controlling interest in the business.  Combined they control 50.4% of the voting power.  There were also rumors regarding the current CEO Sundar Pachai being offered multiple positions at different firms.  The founders, seeing his value to Alphabet, provided him with the compensation he needed to stay with the business.  We believe that this is a benefit to long term investors and a nod to the direction the current management team is headed.  

The Evaluation

10 Cap Evaluation

We value businesses as if we were going to buy the entire thing.   Our Ten Cap analysis is very simple.  It ensures that if we purchased the whole business, we would get a return of our entire initial investment over a ten year period.  This analysis does not include any growth metrics and assumes that the business will be steady and constant throughout time.

Using the 2021 annual report, we can see that net cash provided by operating activities was $91.6B. The business spent $24.6B on PPE of which we believe 50% was used for maintaining the business as it is today and the other 50% for the future infrastructure required for the growth of the business.  That leaves us with pre tax owner earnings of $91.6-$12.3+$0.8=$80.1B  

At the time of writing Alphabet had ~13B shares outstanding

Therefor the owner earnings per share is $80.1/13=$6.1615 

If we are looking to recover our entire investment in the business and it does not grow at all for the next ten years our ten cap entry price per share would be $61/share. 

DCF Evaluation

The Majority of Googles revenue currently comes from their advertising business.  They have had a three year average earnings growth above 30%.  While we are aware that we will most likely be experiencing a decrease in demand from the retail sector due to the inevitable recession on the horizon, we feel that in the long term, Alphabets advertising earnings will stay quite consistent and grow at a around 7-10% a year on average.  

We believe that the growth for the cloud side of the business may turn out to be significant.  If this revenue continues to grow at 25% a year from their 2021 amount of $19.2B, by 2032 Cloud Alphabet will be generating $223B in Revenue from their cloud business.  Using a 15% operating margin the cloud business would add $33B to earnings.  Using a operating margin closer to AWS of 30% the earnings would be $67B in 2032 specifically from Cloud. 

We believe that the earnings growth of Alphabet over the next 10 years will average, somewhere in the ballpark of 11-12% negating the other bets portion of the company.  Should any of the bets become successful and accretive to earnings, it would not be outside of possibility to add 2-3% in additional compound growth to Alphabet over the next decade.

Therefore, using a low of 12% and a high of 15% compound annual growth of earnings, with a 15% discount rate, we feel that Alphabet today is fully priced at $100-$160.   Using a 50% margin of safety for our investment, we would consider  creating a position at $80 and increasing it at $50 per share. We expect an opportunity in the near future.

Current Event

Alphabet is currently experiencing several events at once.   First, they are coming out of the Covid-19 Pandemic growth phase which temporarily increased their earnings growth rate.  This reduction in YoY earnings grow has caused the mutual fund managers with shorter investment time horizons to sell the stock hoping for a better price in a few months time.  This combined with a general move downward of all FAANG stocks most likely caused additional selling from momentum traders.  

In addition to short term investors selling their interests, there is an impending recession on the horizon and it is unclear how that will impact advertising revenues in the short term.  That said this is a scenario that ecommerce businesses, specifically advertisers for ecommerce retailers have not really experienced before.  In the crisis of 2007 - 2008 Alphabets earnings only lost $.01 per share and then continued to grow rapidly.  Although we believe this time will be different, and more prolonged, we feel a similar scenario will result in the long term.  

Even though there are events at play, we have not yet reached the margin of saftey entry point that we would like.  At the Time of Writing Alphabet is trading at $117.70. This is fully priced based on our low side long term growth estimates and significantly over priced based on our no growth ten cap evaluation methodology.  That said this may be a decent entry point for those looking for Growth At a Reasonable Price (GARP).