- Down 28% year-to-date, GOOG looks like an obvious buying opportunity.
- But given the external dynamics, the matter is not so simple.
- In the long term, the stock is doing well. But GOOG isn’t the bargain it seems to be right now.
At first glance, there seems to be an absolutely compelling case for buying Alphabet (NASDAQ:) (NASDAQ:). One of the best companies in the world has seen its share price drop 28% this year, and the drop could be seen as a significant overreaction from a jittery market.
After all, GOOG seems exceptionally cheap today. With cash of about $18 per share on the balance sheet (net of debt), the stock is trading at less than 17 times consensus earnings per share estimate of $5.13. But even that understates the case.
Alphabet is not just Google. It also includes Google Cloud and a group of companies known as “Other Bets”. This last group includes, in particular, the self-driving startup Waymo, as well as Verily, a health research organization.
Google Cloud and Other Bets have value but, for now, they are losing money. The main business – called “Google Services”, which includes search, YouTube and Android – generates money. Over the past four quarters, Google Services has generated $96 billion in operating profits.
With a tax rate of 16.2% (Alphabet’s tax rate in 2020 and 2021), that’s $80 billion in net income, or more than $6 per share. Looking at core business only and excluding net cash, Alphabet stock is trading at around 13 times earnings. And that number doesn’t include Waymo, Verily and other investments, all of which have real value despite not being profitable right now.
If Alphabet were just Google Services, the bulls would say there’s no way the market could value this business at just 13 times earnings. But, in fact, this argument may well be incorrect.
Margin risk for Google
In 2018, Google Services generated $43.1 billion in operating profit, or 33.0% of its revenue. In 2021, Google Services’ operating profit is $91.9 billion, or 38.7% of revenue.
This multi-year performance is impressive. But the question for Alphabet is whether it is sustainable. In 2021, in particular, business boomed: Service revenue grew 41% and operating profit soared 68%.
The year 2021 was perhaps the best possible environment for online advertising. Startups from multiple industries were in fierce competition for keywords. Teladoc Health (NYSE:) is among the companies that cited Google’s advertising costs as putting pressure on their own margins.
Consumers are comfortable. Companies that focus on their e-commerce strategies spend a lot to attract these customers. Google Services is a great company, sure, but its performance in 2021 is due more to a positive external environment than any specific strategies the company is implementing.
In other words, it sure looks like Google Services was a “pandemic winner.” And it looks like its profits and, more importantly, its profit margins were at their peak. We have already seen a turnaround during the: Services revenue grew only 10% and operating profit grew only 2%.
If margins return to pre-pandemic levels, that alone represents a roughly 15% negative effect on earnings growth. If the global economy — and Alphabet derives more than half of its revenue from outside the United States — stagnates, revenue could decline as well.
This risk is why the market values GOOG stock the way it does now. Of course, the market is not necessarily right. But there’s a logic behind this sell-off, beyond the fact that rattled investors are simply selling amid the Federal Reserve’s rate hikes and other broader concerns.
Google must win elsewhere
This is the main business problem. The concern stems from the fact that the rest of the business hasn’t really performed well.
Alphabet invests heavily in segments other than Google Services. Over the past four quarters, Google Cloud and Other Bets have posted losses of around $9 billion. But these investments have yet to bear fruit.
Google Cloud is far behind Amazon.com (NASDAQ:) and Microsoft (NASDAQ:) in terms of market share. Waymo faces competition from Tesla (NASDAQ:), General Motors (NYSE:) and many others. Waymo has made progress, but has yet to post an iconic achievement.
Google’s hardware business, whether in smartphones, streaming devices or Nest, hasn’t moved the needle. The Loon project, which aimed to deliver high-speed internet via balloons, has been shut down. Google Fiber still has a relatively small footprint.
Even with the cyclical risk to core ad revenue, there’s a fundamental argument that Alphabet’s investors are getting the rest of the business “for free,” or something like that. But until the rest of the company shows it can create significant value against a market cap of $1.3 trillion, that argument seems a little flimsy.
To be clear, this does not mean that GOOG is short selling, or that it cannot bounce off the support just above $100. And that’s not to say GOOG won’t grow in the long run. This is still a great business; competition in basic research is far behind, even as TikTok threatens the cash cow that is YouTube.
What you have to remember is that the sale is not thoughtless. There are real risks and a real possibility that Google’s earnings will hit a multi-year high. If so, Alphabet stock may seem cheap now, but it won’t be so cheap a year from now.
Disclaimer: As of this writing, Vince Martin is short on Tesla. It has no position in the other securities mentioned.