Alphabet Inc. (GOOG)

Rating: 4-STARS ★★★★

Alphabet (GOOG) is a masterclass in antifragility. Their business grows in spite of macroeconomic events. Their moat is wide and expanding, and they own the best streaming service in the world: YouTube. Last but not least, they destroy competitors through excellent a top-notch network effect.

Pros

• GOOG has almost all market share for search.

• GOOG continues to experiment with uneven upside bets

• GOOG operates a natural monopoly, where the company could be ran by a ham sandwich for years before running into significant problems.

Cons

• They are heavily involved with search. If legislation seeks to break up the company, it will negatively affect performance.

• Heavily reliant on advertising revenue. While some view this as a solid con, I view it as a necessity. An extremely large percentage of humans around the world use Google.com multiple times per day. All kinds of businesses will continue to pay to get in front of those users.

First I’ll dive into the qualitative, then the quantitative.

The Qualitative

Late-Stage Network Effects

One of the things that’s essential to knowing GOOG as an investment is network effects. Network effect describes something that increases in value the more people use it.

The best example of this is the telephone.

1. If 2 telephones, then 1 connection.

2. If 5 telephones, then 10 connections.

3. If 12 telephones, then 66 connections.

Not only does the number of connections increase, but the value of each telephone increases. This is how Google Search operates, by linking users and data across the internet.

The obvious issue here is “what happens when there are no new nodes to add?” That’s when the network becomes a utility.

Utility Disguised as Business

GOOG is a very large business. They’ve gotten so popular that their name is now a verb in the dictionary:

If we are investing in companies that grow, where does GOOG have room to grow? As we can see below, they have a vast majority of market share, while all other search engines are left in the dust.

When a network grows to a certain level, and when enough people use it, it becomes a utility. People depend on it in their everyday lives. The best example of this is electricity, which requires a physical network, and which almost 100% of humans rely on. GOOG is at that point: it’s a verb, and it’s everywhere. Where can it grow then?

There’s an underlying benefit to being a mega network: reinforcing mechanisms enter the stage. This specific reinforcing mechanism helps any network establish themselves against another business that might otherwise steal market share.

Here we have a proprietary tech that grows the more people use it. This is extremely beneficial to both the users and GOOG.

Proprietary Tech Reinforcing Mechanism

Nobody Actually Wants Privacy

If you’ve heard of DuckDuckGo then you know that their entire thesis is that people don’t want to be tracked. This is incorrect, which is why DuckDuckGo along with other search engines are having a tough time growing. People would rather be tracked and have superior experience, than not be tracked and have subpar experience.

Being tracked allows GOOG to offer targeted ads, and targeted search results, which bring people back again and again.

“We don’t store your personal info.” as if it were a feature. GOOG’s lack of privacy is what makes it so great, and GOOG’s competitors are figuring that out too late.

Just-In-Time Knowledge

This goes in-line with the utility argument above, but people are keeping less and less books around. They’re also using their web browsers less and less for retrieving information. That’s because almost all information is available in a moment through Google search on any mobile device.

As we use Google search more and more, our lives become more intertwined with it. As GOOG is more able to sort information in a meaningful way, we will continue to rely on Google search in new and interesting ways.

The Quantitative

Key Statistics

GOOG has a very modest P/E ratio of 16, but this is combined with a 10-year FCF CAGR of 19.7%. (That is quite high). The cherry on top is the 15.2% median ROIC over a 10-year period. You don’t get this by being a mediocre business, but a real powerhouse.

10 years of revenue growth. Look how steady this is. The argument of “business stop buying ads during economic downturns” is false. Businesses stop buying ads that don’t track conversions. Since GOOG tracks conversions, GOOG advertising will remain strong. See the steady increase below:

Even with the recent downturn in tech and the broader market, GOOG outperforms the S&P 500 in the last ten years.

Risk Assessment

I’m rating GOOG’s risk as “low” due to the antifragile nature of the company. GOOG earned record revenues in 2021 following the pandemic, showing just how robust the company is.

Combined with GOOG’s culture of experimentation and growth makes the overall risk of GOOG low.

Earnings Data

Below we see GOOG significantly increasing their earnings per share.

Cash flows look uniform and very healthy. With more than 50 billion in cash from operations, GOOG wisely spends in capital expenditures while keeping free cash flow positive (and growing).

Who Owns It

Below I have a little table of funds and managers that own GOOG with a heavy weighting. For what it’s worth, these investors are placing a large bet on GOOG doing well.

Putting It Together

It becomes even more clear that GOOG is an amazing business when looking at the quantitative alongside the qualitative aspects. One of the cornerstones of a robust business is antifragility, which GOOG has in spades.

Below I rate GOOG’s Leadership, Price, ROIC, EV/FCF, Growth, Antifragility, and Culture. (If you’re not sure what any of these are, see the competitor table below in section 5).

GOOG gets a score of 88. This is pretty high, but not the highest. The major downside right now is merely the price. It’s a great business, but it’s not cheap right now, even after the tech decline in the market.

My 4-star rating reflects my view that GOOG has a strong and sustainable Free Cash Flow margins, antifragile business model, and high Return on Invested Capital. I believe GOOG has a high probability of showing solid returns in the next 5-10 years. I know that advertising is a heavily saturated industry, but the targeted ads sub-industry is ripe for monetization, as it is still the wild west in GOOG’s network of information. We will see new and exciting ways in which GOOG will experiment with the network. It is still early, even with a 90% market saturation.

GOOG operates the world’s most dominant internet search engine. GOOG performs between 80% and 90% of the internet’s search engine queries and close to 90% of all search engine revenue. In addition to search (55% to 65% of total revenue), Google generates ad revenue from its display ad network (10% to 12% of total) and YouTube (10% to 13% of total). Google is nurturing many other businesses, including “moonshots,” with little revenue but tremendous long-term potential, e.g., autonomous vehicles, quantum computing, and drone delivery. Google Cloud is its largest source of non-ad revenue (6% to 9% of total), competing with Amazon AWS and Microsoft Azure.

When talking about GOOG vs competitors, it’s hard to put a finger on it. In keeping with our “business as a utility” theme, imagine if 1 company produced all electricity. Who would you compare them to? It’s the same here.

For reference I added some of GOOG’s self-proclaimed competitors in the comparison table below, although they only compete on a fraction of a business segment, if at all.

From the above we can see that 1) GOOG is in a leage of its own, and 2) there is no direct competitor to GOOG.

Sundar Pichai is GOOG’s CEO. He joined GOOG in 2004 as a product manager where he oversaw projects like Gmail, Google Chrome, ChromeOS, Google Maps, and Google Drive. He became CEO in 2015, succeeding Larry Page. He earned his MBA from Wharton School of the University of Pennsylvania, where he was named a Siebel Scholar and a Palmer Scholar.

In certain businesses, I value founders leading the company, but when a company reaches a certain size it becomes a different thing entirely than when it was created. That is why I think Sundar is a great fit as CEO. It is foolish to think that the best CEOs are all founders, but that these companies evolve, and their needs evolve. Thus, the type of CEO needed evolves.

Right now, Sundar is a great fit.

Let’s start by looking at Price to Earnings. Since GOOG is a mega cap business, its ratio of 25 is somewhat expensive. (As of this writing, GOOG’s P/E ratio is 19).

The price to free cash flow is steady at 28. Again, I would like to see a better price, but you get what you pay for here.

The ROIC for GOOG is amazing. Only 1 year below 14% is an amazing feat. With GOOG being so large, they are wisely allocating capital to keep ROIC high.

It’s nice to see the increase in revenue per share directly influence the increase in free cash flow per share.

Lastly, margins. GOOG not only has great gross margins, but great free cash margins.

It’s worth noting that high margins in a growing comapny can signify premature profit taking, but with GOOG’s case, they have little cost of replication. These high margins are set by the customer by being willing to pay for ads. This is fantastic to see.

While GOOG is not cheap, it is not expensive. It is reasonably priced. The quality of the business is also extremely high. That is why I’m giving it 4 stars as of right now (November 21, 2022).

It will be interesting to watch GOOG’s different segments continue to grow, and hopefully land a moon shot with their extra bets. Although, it is not necessary to land those moon shots, as it is already an outstanding business. I expect Google search, YouTube, and other segments to surpass Wall Street’s expectations in the next 5-10 years.

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