Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) has great fundamentals and is growing rapidly, despite being one of the largest companies in the world. The company is able to increase its top and bottom lines effectively and continue to increase its share buyback programs. While the general tech sector is struggling, Alphabet is outperforming its competitors because of increases to advertising. However, underperformance of Google Cloud poses risks for the company’s future.
Alphabet’s Fundamentals Are Incredibly Strong
Alphabet has some of the most impressive fundamentals in the market. The company is able to grow its revenue and earnings effectively, maintain a strong balance sheet, and utilize its excess cash to increase its share buyback program. The company’s revenue as grown by 23.69% annually and maintains strong gross and net margins at 56.29% and 21.34%, respectively. Furthermore, Alphabet’s Google Services segment accounts for over 92% of revenue, and has multiple subsegments that split revenue effectively.
The company also has a strong balance sheet with lots of cash, a great current ratio, and incredibly low debt.
The cash flows are also very impressive. The operating cash flows have grown by nearly 2.5x while keeping capital expenditures low. Debt and stock have also been retired consistently, except in 2020 when $9.66 billion of debt was issued.
Alphabet’s Q1 Earnings Overview
Alphabet recently reported Q1 earnings and delivered some negative news. While sales were in line with estimates at about $56 billion, earnings came in at $24.62 per share ($25.71 expected) due to increased costs and worse-than-expected performance from YouTube. YouTube is not growing as rapidly as it has in previous years due to the rise in popularity of TikTok, which is now becoming one of YouTube’s fiercest rivals for the most-used platform for viewing mobile videos.
The Rise Of TikTok Is Not As Bad As Some May Say
Some say the rise of popularity on TikTok also is a risk for Alphabet. A recent survey by Cowen states that TikTok is a new great way to advertise compared to other networks, including Google. As mentioned previously, TikTok is becoming a huge rival for viewing mobile videos, especially among a younger audience. In 1Q21, 45% of people said YouTube was the most often used platform for viewing mobile videos. This number decreased to 35% in 1Q22, while TikTok increased to 22%.
In YouTube’s defense, I think it is important to mention the types of videos on each platform. As for short videos, TikTok is definitely the leader in this category. On the other hand, YouTube is still the clear leader for longer and more in-depth videos. Although TikTok did release a new feature where creators can upload videos up to 10 minutes long, the feature is not very popular and cannot compare to YouTube. Currently, the average length for a YouTube video is 11.7 minutes and while the average length of a TikTok video is about 25 seconds. This allows YouTube to place multiple ads onto one video, instead of only having one advertisement per roughly 10 TikTok videos.
Furthermore, Google is still figuring out how to properly price YouTube ads to continue growing subscribers, as well as popularizing YouTube Music, Premium, and TV. Also, high inflation will likely lead to price-hikes by Google and help gain back its disappointing revenue.
The Tech Sector Is Struggling, But Alphabet Is Outperforming
A major theme in the market recently is the downfall of tech. With the Nasdaq being down about 25% YTD, and some tech giants being down 60%-70% in the past 6 months, many investors are being scared away from tech. Some companies, such as Meta (FB), are blaming Apple’s (AAPL) changes to privacy settings for their decrease in revenue. Meta and many other companies, such as Amazon (AMZN) and Robinhood (HOOD), are cutting back on hiring, and even laying some of their workforce off.
However, Alphabet is still going ahead strong. Google collects its own data on users through Search and YouTube and is not being nearly as affected from changes in advertising compared to its competitors. As mentioned before in Q1 earnings, Alphabet was able to achieve $56 billion in revenue, mostly due to increased advertising in Search. Google advertising revenue grew about 22% in the first quarter, showing that Alphabet continues to improve despite tech pullbacks. For investors who are looking to invest in tech, but are afraid of underlying issues with advertising, Alphabet may be a safe haven.
Google Cloud Is Far Behind Its Competitors
It is clear that Google Cloud is not as strong as its competitors. With huge players like Microsoft (MSFT) and Amazon in the mix, Google Cloud is struggling to gain market share.
As seen in this graph above, Google Cloud cannot seem to grow as fast as Microsoft’s cloud services. Furthermore, Google Cloud has lots of ground to gain before even coming close to the market share of AWS. While sales did grow 43% since last year to $5.8 billion, the segment has yet to be profitable and is even experiencing worse-than-expected operating losses. To try to increase the popularity of these services, it was announced that a Web3 team was formed to capture customers from the increasing popularity of cryptocurrency and blockchain. But some are skeptical about this move. Many say cryptocurrency is not going to be around for the long run, and this group faces fierce competition from giants such as Meta and Amazon.
Based on current fundamentals, Alphabet appears to be undervalued. When conducting a DCF with the company’s WACC of about 8.42% as the discount rate and applying it to projected free-cash-flows, a fair value of $2968.97 can be calculated. This would mean that Alphabet’s stock has an implied upside of 30.42%.
A relative valuation tells a similar story. When using analyst estimates for FY23 and combining these with Alphabet’s historical average ratios for revenue, EBITDA, and EPS, a fair value of $3,178.50 can be calculated after adjusting for the company’s cash and debt to arrive at market cap. This means Alphabet would have an implied upside of 37.24%.
Something interesting to note is analyst and investor price targets for Alphabet. Many other tech companies are being seen as highly overvalued in the current market, but Alphabet is still being seen by many as undervalued. For example, Truist has a price target of $3,500 and Jefferies has a price target of $3,400. Currently, the average analyst price target sits at about $3252.22, meaning Alphabet could be undervalued by about 43.7%.
What Should Investors Do?
Alphabet is a fundamentally impressive company and is outperforming many of its competitors in the tech sector due to not being severely affected by Apple’s changes to privacy. The company continues to grow at a rapid pace, but faces some fierce competition from giants like Microsoft and Amazon. It is important to mention that the competition from these companies is in Alphabet’s relatively small business segments. With Microsoft and Amazon cloud services challenging the Google Cloud segment (7.5% of total revenue), the consequences from this competition will likely not be severe to Google’s fundamentals. Furthermore, YouTube is still the only true player for viewing longer mobile videos and can capitalize on its ability to place multiple ads onto one video and raise prices due to inflation. Combine this with the fact that Google is undervalued and the increased share buyback program, I believe applying a Buy rating is appropriate at this time.