Alphabet (NASDAQ:GOOGL) Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL) has recently seen its shares trade off from $193 to $158, representing a more than an 18% drop, as investors have arguably been discounting both competitive and regulatory pressures the company is currently facing.
We think this recent decline is largely exaggerated and that the stock is starting to get cheap again, both fundamentally and relative to industry peers. In addition, we also think investors may be discounting and overlooking the Google parent's moat relative to other big tech players, which are trading at significantly higher valuations. Finally, we look at the risks to our thesis and what investors should be aware of when looking at the stock.
Google's moat is underratedOne thing we think is often overlooked when analyzing Alphabet is the qualitative aspect of how much moat the company actually has. While it is easy to judge Apple (NASDAQ:AAPL)'s iPhone moat and ecosystem, Google has done a pretty good job of being a stronghold for consumers in multiple domains, with some services seen as very essential.
In fact, we believe consumers would find it difficult to see a world without Alphabet's ecosystem, which ranges from Gmail, Android, Google Cloud, Google Drive, Google Meet, YouTube, Google Maps and Google News, to name a few. In addition, after all these years, we think the company has created a very strong brand loyalty among its users, most of whom choose Google Chrome as their default web browser even when presented with another choice.
Earlier this year, in March, new rules went into effect in the European Union, allowing users to choose which default browser to use, but this did not seem to have a substantial impact on Google's market share, which is another sign of its strong brand loyalty. We believe that even if Google is ordered to stop making payments to other companies, such as $20 billion to Apple (NASDAQ:AAPL) for using Google Search as the default Web browser, it probably would not hurt Alphabet as much as it would hurt the other companies in question.
In general, just the data advantage Alphabet currently has over competitors, as well as the perceived accuracy advantage they seemingly have with Google Search, seems to be a dealbreaker for many users. Regardless, Google Search remains Alphabet's bread and butter, with the segment accounting for more than 57% of total revenue.
Another reason we think the company's moat is undervalued is the fact some of Google's business units, such as YouTube, could be worth more than publicly traded top-tier competitors. For example, YouTube ads alone pulled in $7.67 billion in ad revenue in the second quarter, compared with Netflix (NASDAQ:NFLX), which earned $9.56 billion in revenue last quarter. YouTube, on the other hand, has 2.7 billion active users versus Netflix, which has 277.65 million active subscribers.
Moreover, we think YouTube is just at the beginning of monetizing its user base with YouTube Premium. In general, it would be quite conservative to give YouTube a rating similar to Netflix's, even though the number of minutes watched annually on YouTube is significantly higher than Netflix. Netflix, on the other hand, is currently trading with a market cap of $292 billion. And while many pointed out that YouTube's revenue this quarter fell short of expectations by $8.67 billion, or 13.02% year over year, revenue from Google Subscriptions, which includes the strong growth of YouTube Premium, rose 14.37% year over year to $9.31 billion.
Google Cloud is also gaining momentum, with operating income up $395 million to $1.17 billion, while margins increased from 9.40% last quarter to 11.30% this quarter.
Valuation headed for cheap territoryOne of the most attractive features of Alphabet among big tech players, more specifically the Magnificent Seven, is the fact it is the cheapest of them all at certain valuations. On an enterprise value/Ebit basis, for example, the stock trades at only a ratio of 18.37, compared to other Magnificent Seven companies that typically trade at a multiple of at least 20 to 35 times.
Overall, also looking at forward-looking estimates, Alphabet is trading at a mere 15.82 times 2026 forward price-earnings, against an expected $10.01 earnings per share. Moreover, the company has a massive $100.73 billion buffer of cash on its balance sheet. However, we noticed quite a difference between the figures in the income statement and free cash flow.
For example, if we look at operating income on a trailing 12-month basis, free cash flow usually follows operating income pretty closely. In this case, we looked at free cash flow net of stock-based compensation. As you can see, as of the third quarter of 2023, adjusted free cash flow is significantly lower than normal compared to operating income. This difference is mainly due to higher investments due to spending on hardware for AI infrastructure, as well as changes in accounting from 2023, extending the life of their servers and hardware from four to five years to six years. With respect to the significant investments in AI infrastructure, it also remains to be seen whether this will translate into future flows of free cash flow.
Another key benefit for Alphabet investors is the fact it has used almost all of its free cash flow and sometimes some of its cash reserves to return capital to investors in the form of share repurchases. On a trailing 12-month basis, the company has repurchased $63.36 billion worth of shares while generating $60.79 billion in free cash flow. Outside of innovation in AI models, Alphabet is still going strong with initiatives such as Waymo, expanding its autonomous car fleet and recently partnering with Uber (NYSE:UBER) to integrate with existing Uber customers.
The bearish thesisHowever, there are risks to our bullish thesis as there are some macroeconomic and regulatory headwinds to keep in mind. First, in terms of legislative risks, Google is under scrutiny from several angles, both in the EU and in the United States, mainly regarding antitrust issues. In the United States, a judge recently ruled that Google Search is a monopoly, with the current lawsuit, with the plaintiff's request to have the company at least sell Google Ad Manager, ongoing, according to a report.
In the EU, the company just lost its appeal against a $2.42 billion fine over its comparison shopping service. Alphabet is also fighting two other fines around Google's practices with Android and the Google AdSense platform. The way we see these issues is that most of these rulings are likely to take several years to resolve, especially if it appeals. Moreover, by the time there is a ruling, Google may have enough competition from AI, for example with OpenAI's SearchGPT over ads. The company should also be able to easily pay these fines with the huge amounts of free cash flow it generates, as highlighted earlier.
The biggest problems we believe Alphabet may face in the short to medium term are at the macroeconomic level. First, the yield curve, more specifically the spread between the two-year and 10-year yields, is back in positive territory after being deeply inverted for about two years, which is a strong indicator that a recession is likely near. The Sahm Rule, which indicates the change in unemployment, also recently crossed the 0.50 threshold and currently stands at 0.57. At 0.57, a recession is usually imminent. Previous times when this value reached 0.57, there was always a recession.
While many investors will view the recent announcement of interest rate cuts by the Federal Reserve positively, we want to remind people that interest rate cuts are reactive and not preventive. Usually, when interest rates are cut, unemployment has already risen dramatically and the United States is already in recession, with stock indexes down significantly. In addition, we would also be wary of insider trading in recent years with Alphabet, given that there have been almost no insider purchases and quite a few insider sales by management and directors.
The bottom lineIn conclusion, we think Alphabet is getting cheap on both a fundamental, historical and relative basis, with the stock likely trading at a discount to other big tech companies due to what we see as overblown competitive and regulatory pressures. We also think investors are discounting or overlooking Google's moat in several areas.
In reality, Alphabet is not just another search engine, but a company that has a huge data advantage over its competitors and is able to provide a far superior service, as evidenced by the fact it did not lose material market share in the EU following a decision to let consumers decide which browser to use. The main downside that we think investors should consider at this time is on the macroeconomic front, where we think a recession is very near and could negatively impact Alphabet in the short to medium term. Finally, we would also pay attention to the widening gap between free cash flow and operating income in upcoming earnings reports.
This content was originally published on Gurufocus.com
