Google: Re-Rating Seems Warranted
Contributor since 2011 / 24253 Followers
Summary:
- Alphabet has seen strong returns in its share price as investors are somewhat relieved.
- Revenue growth is accelerating which is comforting as the AI concerns have been alleviated a bit, in part as the company looks to fortify its market position here.
- I like the long-term set-up, despite the fact that Alphabet is still somewhat concentrated in its activities, having the most to lose from the rise of AI.
Justin Sullivan
In a week in which many mega technology firms released their second quarter, including Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), it was these same results which pleased investors as shares have come to life again.
While many technology companies have seen share price approximate the 2021 highs, or even exceed it, that is not yet the case for Alphabet, warranting an update on the investment thesis here.
Even as I regard Alphabet to be among the least diversified technology firms, with perhaps the most to lose from AI, it still trades at a very reasonable multiple, holds a massive net cash position, and is looking to defend its market positioning in a vigorous fashion.
Expectations Normalized
With Alphabet being $70 stock pre-pandemic and shares having risen to a high of $150 in the fall of 2021, the run higher in the shares actually lagged some of its technology peers. Amidst a retreat in valuations in 2022 shares fell below the $100 mark in the fall of 2022 and actually traded below these levels until March of this year.
This came as there were some moving parts around the investment case of Alphabet, which included the rise of AI which not only could threaten Google’s so important search engine, but cloud growth was coming down in a competitive environment as well.
Shares of the company traded at $105 late in April when the company posted first quarter results in which revenues rose 3% to nearly $70 billion, although that constant currency growth came in twice that percentage number. Operating margins fell from 30% to 25%, driven by slower sales growth and charges related to a reduction in workforce and office space.
Given the first quarter results, it was the second quarter results which provided a real sense of relief. Second quarter sales rose by 7% to $74.6 billion, with a stronger dollar now shaving off just two points from reported sales growth. The company furthermore increased operating margins by a point towards 29% of sales, with earnings per share advancing to $1.44 per share.
The company still thrives on the Google advertising business as sales rose by 3% to $58.1 billion, driven by search and YouTube, offset by a small decline in Google network revenues. Other Google sales rose in a solid fashion to more than $8 billion with cloud revenues up more than 27% to $8.0 billion. Earnings improved in a solid fashion as Google performed well; Google Cloud posted an operating profit of $395 million (comparing to a huge loss in the year before) with Other Bets’ losses coming down as well.
These fat earnings made that cash and equivalents increased to more than $118 billion, as the company furthermore held of $31 billion in non-marketable securities. If we subtract $14 billion in debt, net cash comes in at $135 billion for a net cash position equal to more than $10 per share, even as the company remains aggressive with share buybacks, averaging around $5 billion per month here.
What Now?
While the buzz around AI has not yet impacted the results of Google, it is not a given that this will continue. The company itself was quite quiet on AI, only mentioning that it merged Google Research with DeepMind to accelerate artificial intelligence operations in an integrated fashion in the press release, although it was much more frequently discussed on the conference call.
With earnings power currently trending close to $6 per share and net cash seen around $10 per share, it is clear that at $132 per share the company trades at an 20 times earnings multiple, or just above that. This just shows how low expectations were in recent times when shares traded below the $100 mark, actually for quite a while.
The problem with Alphabet is that it is still a mega play on Google’s search engine itself, a unit perhaps being impacted by AI. While other divisions like YouTube and Google Cloud show solid growth, they are relatively small, with the company having relative fewer business lines versus some competitors (notably Microsoft (MSFT)).
In that sense, it was comforting to see solid growth at Cloud, although it remains a small business for Alphabet, now making up just over 10% of sales, although it started to contribute to profits, as Other Bets has been a multi-billion bleeder for years now, with relatively little to show for it.
On the positive side, beside the improved margins and earnings, Google is actually starting to benefit from interest received on its cash position, creating another benefit on the bottom-line results, as interest income for the quarter essentially doubled (year-over-year) to $892 million, which comes in at an effective annual yield of just 3%, indicating that this number will likely jump further in the coming quarters.
Concluding Remark
It is very much the case that shares of Google have seen a big re-rating in recent times, and while I hate to chase shares on the way up, the overall valuations remain quite reasonable and defendable. With growth returning and net interest income on the rise, the $6 earnings per share number (at least in the form of a run rate) should be safe, as I (like many other investors) found comfort in the fact that AI remains at the forefront of investments and focus on Alphabet here.
While AI is actually a bigger threat to Alphabet compared to many peers, and the company being less diversified than some peers, it is a bit cheaper as well, as the company still has strong monopolies in some key business areas. Alphabet furthermore has a huge and strong balance sheet to make targeted deals (although that is not a major issue for many of its larger peers, with anti-trust issues being a bigger threat than dealmaking ability being hampered by financial capabilities).
Hence, this remains a long term investment acting as a cornerstone in my portfolio, as I see no reason to chase the way up here.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOGL either through stock ownership, options, or other derivatives. 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.
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