Investment Case: Alphabet Inc.
World-Class Quality Selling at a Discount
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Hello fellow investors!
Welcome back to the JB Global Capital Newsletter. Today, we will be going through our investment case for one of our portfolio companies Alphabet Inc. As always thank you for being a part of our growing community. The following write-up is for informational purposes and not intended as investment advice.
“Google is not a conventional company. We do not intend to become one. We have emphasized an atmosphere of creativity and challenge, which has helped us provide unbiased, accurate and free access to information for those who rely on us around the world.”- 2004 Founders' Letter
Business Overview:
Alphabet Inc. is a collection of businesses which in aggregate, place the company amongst the highest quality franchises throughout the world. If you are reading this, there is a high probability that you use one or more of Alphabet’s products or services on a daily basis. From a high level, the business generates revenues in three major ways:
Online Advertising (80.3% of Total Revenue)
Apps, Hardware, Content (10.4%’)
Cloud Computing Services (9.3%’)
Alphabet has strong competitive positions in each of their major operating segments. The company has a natural monopoly in their Google Search business, which handles over 90% of all search queries worldwide. They own the world’s most popular video-sharing site, YouTube, with over 2.6 billion active users as of 2023. Technically, YouTube is the second largest search engine after Google.
In the OS market, Alphabet’s Android holds a 72% global market share as of Q1 2023, effectively competing in a duopoly with Apple’s IOS. By launching Android in 2007, Google positioned itself well in the faster-growing mobile advertising market, maintaining its online search dominance and strengthening its network effect. Google's Chrome browser remains the global market leader with 66% share, compared with 19% for Apple's Safari and 4% for Microsoft's Edge. The company’s cloud division, Google Cloud Platform (GCP), is the third largest in the world, trailing behind Amazons AWS and Microsofts Azure. The company also owns a massive investment portfolio with roughly $92B in marketable securities and another $30B in long-term investments through their subsidiaries, CapitalG and Google Ventures.
Why We Like the Business:
Alphabet’s businesses are supported by powerful global tailwinds of expanding high-speed Internet access and increasing digital transformations across world economies. These secular trends drive the proliferation of web usage, content creation, digital advertising, mobile computing, streaming entertainment, and cloud computing. The company sits squarely at the center of each of these trends, and as the established leader, is best positioned to capitalize on the winner-take-most dynamic associated with platform businesses. We believe that Alphabet has a broad-based competitive advantage related to the data-collection capabilities of their various ecosystems. The company has been able to build this advantage over the prior two decades by providing high value products and services at no cost for users, combined with superior technological expertise in machine learning.
The phrase "Google it" has become culturally synonymous with searching for accurate answers to queries, demonstrating the relevancy and trust between users and the product. Alphabet’s business capabilities improve incrementally as more data is funneled through their entire ecosystem, creating a flywheel effect. As digitization trends continue to move up and to the right, we do not see this flywheel stopping anytime soon.
Enlightened Management
We admire Alphabet’s founders and current management for their core values and long-term vision. The company has purposefully under-earned in the short term in pursuit of maximizing user value. In their founder’s letter, Larry Page and Sergey Brin explicitly stated this vision and we find that it still holds true today,
“Our goal is to develop services that significantly improve the lives of as many people as possible. In pursuing this goal, we may do things that we believe have a positive impact on the world, even if the near-term financial returns are not obvious.”
When analyzing technology companies, we focus on the ability for the business to attract top talent. While the company has been recently cutting-back on employee perks, we believe that Alphabet has both the cultural reputation and financial strength to attract and retain top software engineers and product managers. The company has consistently topped the list of Glassdoor’s “Best Places to Work” since 2009 and currently has a 4.4 out of 5 stars based on ~42,000 employee reviews.
In terms of capital allocation, Alphabets management has proven to be exceptional. It appears that management aims to remain ahead of competition by acquiring valuable assets to utilize and build upon as it did with Android, DoubleClick, DeepMind, Waze, Fitbit, and YouTube.
Google purchased YouTube in 2005 for $1.65B. In 2022, YouTube’s annual revenue amounted to $29.24B. Assuming a conservative sales multiple of 3x would value the business today at $87.72B; generating a market beating annual return of 27% over the 17-year period. We view YouTube as a phenomenal business as it benefits from user-generated content and powerful network effects that align interests for owners, advertisers, content creators, and viewers. Given the large amount of cash and low debt on Alphabet’s balance sheet, we believe management is highly capable of making accretive acquisitions into the future.
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Valuation:
Good investment opportunities often present themselves with a confluence of negative headlines and concerns over market disruption. We believe that the circumstances that led to our investment in Alphabet are no different.
Some of these market concerns include rising competitive pressures from Microsoft’s ChatGPT, antitrust lawsuits from governments and companies around the world, and a potential recession-induced downturn in online advertising. The company also did not do their shareholders any favors when they made a marketing blunder in their first demo for their A.I. Chatbot, Bard. We are of the opinion that aside from rising competitive pressures, these concerns should largely be ignored by long-term investors. While it is plausible that Microsoft can take some market share in Search, we find that (a) the market is large and growing fast enough to sustain multiple players and (b) Alphabet has the technical capabilities and competitive positioning to maintain market dominance for many years to come.
When analyzing Alphabets financials, it’s hard not to be impressed. The business has been able to grow revenues at a CAGR of 20.6% over the past 5 years, while maintaining an average FCF margin of 21.31%. With ROE and ROIC during the same period averaging in the mid 20s, it is clear that Alphabet is an exceptionally high-quality business. The company has also been accelerating share repurchases as of late. In 2022 alone, Alphabet bought back nearly $60B of stock, more than Amazon’s and Microsoft’s buybacks combined. We believe that given the company’s financial health and free cash flow generation, share repurchases can continue to generate value well into the future.
As of writing, Alphabet currently trades at a market cap of $1.36T or $106.32 per share. Using a DCF model with a conservative 9% growth rate over the next five years and a WACC of 7.74%, we arrive at a fair value of $138.60 per share. This would indicate that Alphabet is currently undervalued by 30%.
When valuing the business using a multiple-based methodology, we come to a similar conclusion. The peer group we chose for our relative valuation include MSFT 0.00%↑, AMZN 0.00%↑ , AAPL 0.00%↑ , and META 0.00%↑. Focusing on the metrics of Sales, EBIT, and FCF, we arrive at the respective average multiples of 4.58x sales, 23.69x EBIT and 27.65x FCF, giving us a blended relative valuation for Alphabet of $130.96 per share. This would indicate that Alphabet is currently undervalued by 23%.
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Sincerely,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.