The bear market of 2022 has removed a great deal of froth from the Everything Bubble that resulted from unprecedented money-printing and economic stimulus. It’s been an exciting time to be a value investor in that many growth stocks are turning into prime value candidates, and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) is a prime example of that. The stock trades at around 19x forward earnings, which is down from 25x at the beginning of the year. While I have no clue if the stock has bottomed, I do believe that Mr. Market is providing us with the opportunity to buy one of the highest quality businesses in the world at a very undemanding valuation, making for compelling future investment returns.
I remember when the Google IPO occurred on August 19, 2004. I had just graduated college in June and started working at Vanguard in Scottsdale, AZ. I didn’t have any money to invest, nor did my $28K annual salary offer bright prospects, but my coworkers and I spent a lot of time debating the merits of the stock. Younger investors accustomed to the obscene crypto and speculative hysteria of the last few years might be surprised to know that there was a lot of skepticism about Google back then, mostly because the 80% crash in the Nasdaq had made most investors gun-shy to pull the trigger on new tech stocks. It would be like if we saw a few more Luna-type events and continued declines in prices for several years to come. Yahoo was still strong and after seeing the Search business leadership position change several times since the internet era began, it was tough to imagine Google staying on top for decades into the future. Investors smart enough to buy the IPO at $85 have obviously seen an unbelievable return on their investment, and Google has presented many good buying opportunities over the years, all at substantially higher valuations than the current one.
The company has executed phenomenally well, making big bets that have helped it dominate industries, such as Search, mobile operating systems (Android), and internet videos (YouTube). Short-form videos are the craze currently led by TikTok, but YouTube is holding up well, averaging over 30 billion daily views, which is up four times as much as a year ago. Alphabet is now making material inroads in AI, the Cloud, and Multi Search. These efforts are enabled due to the company’s prodigious R&D spend, which was nearly $30B per annum over the last two years, and $100B over the last five years. I’ve invested in Google many times over the years, but I became more comfortable when Ruth Porat joined the company as CFO in 2015. I had followed Ruth for years, as she did an exemplary job in the same position with Morgan Stanley (MS), and I believe she brought a bit more accountability to the company. A company that generates this much cash flow needs to earn adequate returns on that cash, instead of destroying shareholder capital, and I think Google generally does a decent job with that. Over the last decade, Alphabet has grown its revenue from $46B to around $270B. Alphabet generated $67B in free cash flow in 2021. According to Barron’s, the company is expected to produce roughly $339B between 2023 and 2025.
Alphabet has built truly world-class advertising technologies for its customers to run their digital marketing businesses. Google’s competitive advantages continue to grow through the collection of data, allowing the company to provide the right ad at the right time. Google Services generates revenues primarily though selling ads on Google Search, YouTube, and Google Network partners’ properties. Google Play generates revenues from sales of apps and in-app purchases and other digital content that is sold in the Google Play store. The company has also increased its activities in Hardware with sales of Fitbit wearable devices, Google Nest home products, Pixel phones, and other devices. YouTube has made major progress generating revenues from both YouTube Premium and YouTube Tv subscriptions, both of which I am a subscriber to. I will use my tiny platform to mention that I believe the censorship campaign employed by Big Tech in general including Alphabet is an absolute travesty. Open dialogue of ideas, inclusive of differing opinions are imperative to democratic ideals. The idea of partisan “fact checkers” censoring those who often prove to be right in hindsight, simply for differing from the consensus view is one of the most worrisome developments in society as far as I’m concerned.
Google has been investing heavily into its Cloud business. It has been spending billions in infrastructure, security, data management, analytics, and AI. These services allow businesses with features like data migration, machine learning, and services such as Google Workspace. Developers can build, test, and deploy applications in a highly scalable and more reliable infrastructure in Google’s Cloud. The business is certainly running behind Amazon’s AWS and Microsoft’s Azure, but the market is big, and Google can’t cede it to its competition without a fight.
Google reported 1st quarter 2022 revenues of $68B, which were up 23% YoY, or 26% in constant currency. Operating income was $20.1B, up 22% and the operating margin was 30%. Other Income & Expense was a loss of $1.2B, due to unrealized loss in the value of investments in equity securities. Net income was $16.4B, while free cash flow was $15.3B and $69BTTM. Google Services revenues were up 20% to $61.5B. Google search and other advertising revenues of $39.6B, were up 24%, led by retail and the recovery in travel. YouTube advertising revenues of $6.9B, were up 14%, as direct response growth slowed down a bit in the quarter, as we’ve seen with other companies as well. Much of this should have been expected considering the comps the company is lapping from 2021. Network advertising revenues of $8.2B, were up 20%, driven by AdSense and AdMob. Other Revenues were $6.8B, up 5%. Google Cloud revenues were $5.8B, up 44%, but generating an operating loss of $931MM. This is a scale business and once the unit starts reporting profits, that will obviously remove a substantial headwind to operating profits.
Google trades at roughly 19 forward earnings, which is down from 25x at the beginning of the year. The free cash flow yield to enterprise value is nearly 5%, which is quite attractive being that free cash flow is poised to keep growing. Sales and earnings are expected to grow by 15% and 19%, respectively, in 2023 from 2022. Consolidated revenues grew by 41% between 2020-2021, while operating income grew by 91%. The pandemic/lockdowns accelerated the digitization of the global economy and naturally Google was a major beneficiary. Advertising is indeed cyclical as investors are finding out again in 2022, but Google will continue to build its moat and earnings over time. Operating cash flow was $91.7B in 2021 and capital expenditures were $24.6B. The company spent $50.3B in share repurchases in 2021 and $52B over the last twelve months. These massive cash flows allow the company to keep growing its many businesses with investments, while still returning substantial capital to shareholders. With the recent drop in share price, buybacks are going to be enormously accretive.
Total cash and short-term investments of $133.970B and only $28.602B of total debt, highlight the exceptional financial strength of the company. Of course, the stock can get cheaper in a weak market, but Google has generated consistent returns on total capital in the teens, despite heavily investing in the future. Putting a 25x earnings multiple on forward earnings, puts the stock right near $3,000, which is roughly 32% higher than the current share price. Even if you don’t get multiple expansion, Google’s earnings will continue to grow, providing double-digit per annum return potential from these levels. If you are willing to accept short-term mark to market risk, which you better be if you are investing in stocks, the long-term risk profile seems low investing at current valuations. I’ve been dollar-cost averaging slowly and plan on continuing to do so.