- Alphabet once again trades near $1,000, as headlines pull the stock down.
- I see several feasible catalysts to drive the stock price higher.
- The company has a rock solid balance sheet, but why isn’t it monetizing it?
- GOOGL is a conviction buy.
Alphabet (GOOG) (GOOGL) has languished in the past several years, as it has underperformed the other tech giants and basically been a market performer. The recent DOJ news has brought the stock near the 1,000s yet again – I explain in this article three catalysts that can immediately create tremendous shareholder value. I rate shares a conviction buy.
DOJ And The Clouds And The Opportunity
GOOGL shares slid 6% in the same day that reports surfaced stating that the DOJ May investigate the company for hampering competition.
I am not sure how this will all turn out, but history gives me confidence that the actual impact to the business operations of GOOGL are unlikely to be anywhere near that feared. For example, Microsoft (MSFT) has performed spectacularly since its investigation by the DOJ. This fear in my opinion has created a tremendous buying opportunity.
Incorrect Headlines? Adjusting The Earnings
In the first quarter, GOOGL saw revenues grow 17% YOY or 19% on a constant-currency basis. At first glance though, it saw a 10.7% decline in EPS even after excluding the fines from $13.33 per share last year to $11.90. I wonder if some investors sold for this reason.
However, in 2018, all companies adopted the new accounting standards which required them to list unrealized gains on securities on their income statement. Excluding these unrealized gains, we can see that GOOGL saw adjusted EPS grow 14% (also excluding fines):
These are pretty good numbers, but it is becoming clear that the stock seems to be trading in a range due to the poor headlines as well as even more self-inflicted wounds. I share below some potential levers our company can pull to increase its valuation.
Spinoff Of Waymo
When one thinks spinoffs and GOOGL, the first that might come to mind is spinning off YouTube. I however have a different idea in spinning off Waymo, our self-driving car business. While this is supposedly one of the company’s fastest growing units, it also is presumably very cost intensive. Waymo is nestled under its “Other Bets” division which had very little revenues but substantial losses:
It is weird to me that GOOGL but we’be been directing so much capital towards this division, capital that could have instead went towards shareholders. That’s an expensive use of cash.
If Waymo were its own standalone company, it might be able to fetch a high valuation and thus raise capital much more cheaply. I hate to use these as examples, but consider the recent IPOs of Uber (UBER) and Lyft (LYFT), which both fetched rich valuations, as well as Tesla (TSLA) which for many years has commanded a valuation premium much higher than that of automaker rivals. I am unsure how to place a valuation on Waymo, but I think odds are that it can tell a compelling story and raise significant capital through secondary raises, which would be a much cheaper cost of capital.
How much value could be created? Even ignoring the value of Waymo, if the losses from the Other Bets were to perhaps drop to $300 million, then net income would jump 10%. Shares would thus trade at 22.6 times “core earnings” and just around 19 times after subtracting cash. Then there would be the value in Waymo.
That said, I don’t see this to be very likely as at GOOGL we have not shown to run by the most shareholder-friendly management as evidenced by the existence of the next potential catalyst.
Increase The Share Buybacks
GOOGL did increase its share repurchases this past quarter to around $3 billion, which was $1 billion more over last year. This however could be viewed as still a disappointing amount considering that it actually had just over $7 billion in free cash flow. What happened to the other $4 billion? GOOGL let its cash pile grow from $109 billion to $113 billion. I think the easiest and most realistic thing for GOOGL to start doing is returning free cash flow back to shareholders in the form of share repurchases instead of letting the already absurd cash hoard (more on this next) continue accruing even more cash. Given that shares trade at just around 25 times 2018 earnings (and that’s prior to adjusting for cash), shares are more than reasonably priced, and I just don’t see the justification for letting the cash position grow.
More Buybacks: $100 Billion Of Cash
But why stop there? By the same logic, not only does GOOGL not need an increasing $100 billion cash hoard, but it also doesn’t need a $100 billion cash hoard in the first place. While some argue that the company “needs it for growth,” I on the other hand point out that it is already fueling growth through R&D, and the cash hoard continues to grow even after that. Consider that the cash hoard equates to roughly 15% of the market cap. On a cash-adjusted basis, GOOG trades for just over 21 times earnings, which is very cheap for a company growing earnings double digits. If GOOGL were to monetize its cash hoard, then it might do it by issuing debt and first aiming for a “debt neutral” position (equal amount of debt and cash). This allows the company to monetize its position through share repurchases while at the same time giving the same flexibility that holding cash did because, well, it’s still holding cash. It is arguable that a company with the high quality of earnings of GOOGL would even be allowed to take on considerable leverage, but for now a debt neutral position would already be a great wish. Technology peers Microsoft and our Apple (AAPL) have already began pursuing such strategies, and it is arguable that their recent stock price performances in part reflect this shareholder-friendly capital allocation decision (note that the price chart does not even include dividends):
I have a hunch that it is only of a matter of time that the cash hoard gets addressed or an activist steps in to accelerate the (inevitable) decision.
Start A Dividend
Growth companies can’t pay dividends, right? This wildly incorrect statement has long been a way to excuse the fact that some companies like GOOGL aren’t distributing cash back to shareholders through a dividend. While I agree that high return growth opportunities should be pursued over paying out a dividend, cash left over after the reinvestment arguably should be distributed out to shareholders. Should shareholders expect GOOGL to be better stewards of cash? I would have hoped so, but the fact that it’s holding the cash (over $100 billion worth) in low interest-bearing accounts for several years suggests instead that it just doesn’t exactly yet know what to do with the money. Pay out a small dividend, and start buying back stock. This is just a simple and responsible capital allocation decision to make for companies making so much money and a strategy that has worked wonderfully for both MSFT and AAPL as we saw above.
Valuation And Price Target
As mentioned above, GOOGL trades at around 25 times trailing earnings or 21 times after subtracting cash. For a company still growing so robustly, this is much too cheap, and in my opinion, a higher multiple is warranted.
I am projecting for GOOGL to earn about $48 per share in 2019. My 12-month price target is $1400, which would be about 25 times 2019 earnings net of cash. This represents over 30% total return upside.
- GOOGL seems to be fined so much that perhaps we should start viewing the fines as a recurring expense. This is impactful because I have been computing its earnings power by adding back expenses from fines. I think we will need several more years to observe if these fines to be recurring and thus should not be added back.
- Maybe I’m wrong and the DOJ really turns its business model for a spin. Shares still have a premium multiple relative to the market and thus the uncertainty is certain to add significant volatility. Shares definitely aren’t for the faint hearted.
- Revenue growth rates have seen a steady slowdown, suggesting the online advertising market is beginning to reach saturation. At GOOGL we will need to count on the company’s ability to utilize its platform to generate new alternative streams of income, such as through its YouTube Red video streaming subscription service model and Google Cloud.
GOOGL stock hasn’t been a great performer in the past several years, but its underlying financials have been very strong. A spin-off of Waymo and implementation of share repurchases and dividends would go a long way in generating shareholder value. I rate shares a conviction buy with 30% upside in the next 12 months.