In the course of last week, four mega caps from the tech sector delivered their results for the past quarter: Apple (AAPL), Amazon (AMZN), Facebook (FB) and Alphabet (GOOGL, GOOG).
It is worth mentioning that these companies, together with Microsoft (MSFT), currently account for almost a quarter of the S&P 500 (see following figure as of 16 April 2020).
While all companies exceeded analysts’ expectations, there was one company that recorded declining revenues: Alphabet.
A comparison of the year-to-date performance also shows that Alphabet is lagging behind with a performance of ‘only’ 11% (see following figure).
(Alphabet’s year-to-date performance in peer group comparison. Source: YCharts)
Alphabet reminds me very much of Apple at the beginning of the year 2018 when the company was struggling with declining sales and an increasingly saturated market so that the company was valued with a P/E ratio of around 10.
Nevertheless, the narrative about Apple changed in 2019 and the stock has generated a return of more than 150% since the beginning of 2019. Among other things, share buybacks worth tens of billions of dollars and the entry of an anchor investor with Warren Buffett have contributed to this. Furthermore, the contributions of the services and wearables segments have led to a re-evaluation of the stock by investors.
The following chart illustrates the diverging gap between Apple and Alphabet since summer 2019.
(Comparing the performance of Apple and Alphabet since 2018. Source: YCharts)
While the weakness of Alphabet in the consumer (devices) segment, which I mentioned in my article of December 27, 2019, was particularly noticeable this quarter, my assumption of increasing shareholder value following the appointment of the new CEO Sundar Pichai was confirmed once again since the management authorized an additional share buyback program amounting to $28 billion.
In the following, I would like to discuss the results of the recent quarter and which factors could change the narrative and boost Alphabet’s stock price. Additionally I will present my new price target.
(Google Search. Source: Pixabay)
2. Alphabet is most affected by the pandemic among its mega caps peers
While the company was able to exceed the expectations of the Street, investors remained unconvinced so that the stock dropped around 3% on the day following the earnings release while its peers recorded solid gains:
- Revenues decreased year over year by 1.7%, or were stable in constant currency, to $38.3 billion in Q2 (consensus: $37.3 billion).
- Operating income decreased by one third from $9.18 to $6.38 billion, while operating margin decreased from 24% to 17%, though better than the expected 15.7%.
- Net income and earnings per share also decreased by one third to $6.96 billion or $10.13, respectively.
- Free cash flow grew by 32% to $8.6 billion year over year in Q2 which is very encouraging considering the decline in the aforementioned metrics (Q2 2019: $6.5 billion).
The following figure provides an overview of Alphabet’s quarterly results (see red marking):
(Alphabet’s Q2 2020 results. Source: Alphabet)
The main reason for the revenue and profit decline was the drop in the Google ads business, which is Alphabet’s largest revenue contributor and includes revenues generated by Google Search engine and Google Ads. Revenues in Google Search engine and Google Ads dropped by around 10% in each case.
The revenue decline in Google’s advertising business is not surprising as the travel industry has come to a virtual standstill as a result of the Covid-19 pandemic and, according to a Forbes article, around 10% of Google Search revenue in 2019 came from the travel industry.
In contrast, the company delivered strong growth in non-ads revenues particularly from Cloud, Google Play and YouTube subscriptions. The YouTube ads segment managed to achieve an increase in revenues of 6%. The Google Other segment, which includes revenues from Google Play and newer subscription businesses such as YouTube Premium and YouTube TV, recorded an increase of 26% to $5.1 billion. According to CEO Pichai, the company currently has around 22 million subscribers worldwide, up more than 60% versus the prior year.
Google Cloud, which also experienced double-digit growth rates and performed well in the last quarter, grew by 43% year over year. Based on the management’s statements in the earnings call, momentum in Google Cloud remains strong, which is also reflected in a strong backlog by ending the quarter at $14.8 billion. The company managed to sign new multi-year agreements with prestigious customers like Keurig Dr. Pepper, Deutsche Bank, Lowe’s, Telefónica, Orange and Renault. Furthermore, management intends to invest and hire heavily in priority areas like Google Cloud despite cost-cutting measures in other areas.
The following figure provides an overview of Alphabet’s quarterly segment results (see red marking):
(Alphabet’s Q2 2020 segment results. Source: Alphabet)
With regard to the financial situation Alphabet remains very strong with cash and marketable securities in the amount of $121 billion.
Furthermore, the company repurchased $6.9 billion worth of shares and – as I expected in my recent articles – once again increased its share buyback program by an additional $28 billion.
Regarding the future development, management reported that they intend to improve direct shopping features on Google and talked about topics like education and health.
Taking into account the company’s strong cash position, I would not be surprised if there were acquisitions in these areas in the foreseeable future. Anyway, I wonder why companies like Apple, Amazon and Alphabet aren’t pushing the telehealth sector more aggressively since it is one of the most promising growth areas in the future in my view.
With regard to Other Bets, the management reported that Waymo and Renault closed a strategic partnership for level four autonomous technology and Wing’s drone delivery service started delivering library books to students in Virginia. Consequently, there could also be surprisingly positive developments in Alphabet’s Other Bets area in future.
3. Updated fair value calculation implies at least 32% upside potential
Now that we have the figures for the current quarter and the financial impact of the pandemic, it makes sense to provide an update on the fair value.
As mentioned in the section above, the company’s free cash flow increased by 32% year over year despite declining revenues and profits mainly in the advertising business which represents Alphabet’s largest segment.
In order to choose a conservative approach, I have chosen a growth rate of 10% per year in terms of the free cash flow in analogy to my previous articles, since I assume ongoing investments in headcount, data centers and small-scale acquisitions such as Fitbit to strengthen the consumer devices and areas like shopping, education and health. These investments could negatively impact free cash flow in the foreseeable future, according to my assumption.
Furthermore, I have chosen a multiple of 18.26 for the last FCF, which is in line with the average Price/Cash Flow multiple during the last five years, according to Morningstar.
Based on my valuation method, the fair value is $1,969.52, which corresponds to an undervaluation of the stock of 32% (see calculation below).
(Fair value calculation. Source: Author’s calculation)
Nevertheless, the current calculation does not include the impact of the outstanding buyback program. The share buy-back program is very likely to provide a further boost to the share price.
While Alphabet’s advertising business was heavily impacted by the global pandemic and its advertising business suffered due to the nearly complete standstill of the travel industry, its non-advertising business consisting of cloud, subscriptions and YouTube ads performed well.
Taking into account the current weakness of the stock price and growth worries, Alphabet strongly reminds me of Apple in 2018 when the shares were lagging behind its peers.
Nevertheless, I think that as the advertising business picks up and the economy recovers from the effects of the pandemic, the narrative could change rapidly and Alphabet could even double its stock price during the coming two to three years.
Based on my fair value calculation, the stock has an upside potential of at least 32% and could be worth $1,969.52.
At the same time, Alphabet could surprise with acquisitions in the areas of online shopping, education and telehealth, which also represent multibillion-dollar businesses and promise a great future. Not to be forgotten in this context is also the potential that lies behind “Google Other Bets” (Waymo, Wing, etc.).
While every investor has to make up his own mind, I think Alphabet is a buy, but not an overweight. In fact, patience could pay off for the investor in the long run.
Nevertheless, even if the shares appear fundamentally undervalued, unexpected events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.
In the context of headwinds, antitrust probes, digital tax plans and investigations in the context of data collection and data security by public authorities all around the globe could be mentioned. Depending on the results of these investigations, the share price could come under pressure, which could lead to buying opportunities based on the outcome.
PS: I intend to publish more about tech stocks in future. If you are interested in finding out my favorite technology stocks, just follow me on Seeking Alpha, my personal blog, on Instagram or Facebook.
Disclosure:I am/we are long AAPL, GOOGL, GOOG, FB, AMZN, MSFT.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.