META - Google: The Only Tech Mega Cap I'd Buy Now (Rating Downgrade)

2023-09-19 18:27:36 ET

Summary

• Alphabet Inc (Google) is undervalued compared to its big tech peers, with lower earnings multiples and a better discounted cash flow-based valuation.
• The company has strong competitive advantages in search, advertising, smartphone operating systems, and online video, making it a fortress-like company.
• The stock has appreciated but is still worth buying due to its strong profitability and growth potential.
• By contrast, most of its big tech peers are so expensive today that it's hard to see where their upside will come from.

Alphabet Inc ( GOOG ) (GOOGL) aka Google has been getting a lot of love from super-investors lately. Bill Ackman has been steadily adding shares, Li Lu has been overweight the stock for years, and Charlie Munger has gone on the record saying that Berkshire Hathaway ( BRK.B ) " screwed up " by not buying it.

So, you've got a lot of smart people singing Google's praises. Yet still, the stock is not all that expensive-at least not by the standards of its big tech cousins. The chart below contains some earnings multiples for Apple ( AAPL ), Meta Platforms ( META ), Nvidia ( NVDA ), Microsoft ( MSFT ) and Google. As you can see, Google's multiples are, on average, the lowest of the bunch.

The only one of these stocks that's in the same league as Google in terms of valuation is Meta. It has Google beaten on the price/book and price/CFO ratios, but ultimately, Google gets the best three out of five when compared side by side with Meta, while having more growth than that company has. So, Google looks like the overall cheapest mega cap tech stock.

This is very peculiar, because Google's advantages are quite well known. It has seven services with over a billion users each. It has 4.3 billion users total. Google search has a 90% global search market share . Android is the #1 smartphone operating system by installs , and is in a duopoly with IOS, giving both Google and Apple plenty of market power.

Basically, Google looks like a fortress of a company, yet the markets are still lukewarm on the stock, at least compared to its peers. According to the Wall Street Journal, the NASDAQ 100-Index (NDX) trades at 30.5 times earnings . So, Google is significantly cheaper than the rest of big tech while seemingly having some of the biggest competitive advantages of the bunch. This does not mean that Google is "cheap" in absolute terms, but it does suggest that the stock is among the more intriguing buys within its sector.

It's for this reason that Google is currently the most heavily weighted tech stock in my portfolio. The company has an economic moat, a durable competitive advantage that no competitors can match. When Microsoft launched its Bing chatbot, commentators opined that it would inevitably take market share from Google. It didn't happen. Many months after the launch of Microsoft's chatbot, Google's share is still higher than it was in October 2022 . Between Bing and DuckDuckGo, many Google competitors have attempted to take on the King of Search, but none have succeeded. On top of that, other Google services like YouTube and Gmail dominate their sub-sectors as well. Taking into account Google's many moats, we have a plausible case for the company's strong profitability and growth continuing into the future.

When I last covered Google , I rated the stock a "strong buy" because it was both cheap and growing at the time its second quarter earnings came out. I still have basically the same opinion on Google as a company today, but the stock itself has appreciated by 13.6%, and outperformed the S&P 500 (SP500). As a result, I am downgrading my rating to a mere "buy," to reflect the higher price tag.

Competitive Landscape

By far the most important thing about any company is its competitive position. If a company enjoys advantages that keep its competitors at bay, then it is likely to perform well, even if its industry is not that great. Google has the good fortune of enjoying both a moat and a good industry.

First, let's look at those moats.

I covered Google's search moat in the opening paragraphs. The gist of it is that Google's would-be competitors have never managed to take any share from it, despite valiant efforts. DuckDuckGo differentiated itself with anonymous search . Bing was first to market with a chatbot-equipped search engine. Neither one managed to take any share away from Google.

As for the service that is sold on Google, search advertising, that's a bit more competitive. Google is #1 in online advertising, but its market share has been declining over time. Meta, LinkedIn, and even Amazon ( AMZN ) are major Google competitors in advertising . Amazon's ad platform has been growing rapidly. So, Google faces more competition for revenue than it does for users. With that said, Amazon ads are mainly for Amazon listings, LinkedIn ads are mainly for business-to-business ("B2B") offerings, and Meta ads are mainly for small businesses . Google is fairly unique in being an advertising "one-stop shop."

Next up we have Android. It's the #1 smartphone operating system by installs, and #2 by revenue . The smartphone OS industry is a duopoly between Apple and Google. The duopoly nature of the industry means that Apple and Google both enjoy significant pricing power.

Last but not least, we have YouTube. It has a 75% market share in online video. Meta and TikTok compete with it in short-form video, and Netflix ( NFLX ) competes with it in professionally produced content, but YouTube is more or less without competition in long-form user-created video.

Google: Valuation

Having looked at Google's competitive position, we can now proceed to its valuation. Since I already showed the most important multiples at the beginning of the article, I'll use a discounted cash flow ("DCF") approach here.

According to Seeking Alpha Quant, Google had $5.54 in free cash flow per share over the last 12 months. If you discount that amount at the 10-year treasury yield (US10Y), you get a $138.15 price target, which is just about where the stock is now. If you add in a 6% risk premium, you get just a $55.4 price target, implying considerable downside.

The targets above are based on an assumption of 0% growth. Going by history, Google is unlikely to grow at 0% going forward. Over the last 10 years, the company has grown its revenue at 18% CAGR, its EPS at 18.4% CAGR, and its free cash flow at 23.4% CAGR. The company's search moat suggests that it will continue growing its search advertising business as long as the industry continues to grow. The cloud business only recently became profitable, and it did so while growing revenue at 28%. The strong top line growth combined with the recent breakeven suggest that Google's Cloud segment will deliver positive growth in the future.

It's hard to say exactly how much Google as a whole will grow going forward, but if we assume that it can grow at 10% for five years and just 2% in perpetuity after that, we get a $159 price target, which suggests 15.2% upside using a 7% discount rate (7% is the mid-point between the treasury yield and the higher discount rate that incorporates a 6% risk premium). The amounts of growth assumed here are far below the historical averages for Google, so there's a good chance that the company will be worth more in the future than it is today.

Risks and Challenges

As we've seen, Google is the most sensibly valued of its mega cap tech peers, and has a strong competitive position. It certainly looks like a buy - or at least the best buy among its peer group. To my mind, Google is worth owning; it's the most heavily weighted tech stock in my portfolio right now. Nevertheless, the stock faces many risk factors, including:

• Interest rate hikes: If you followed along in the section on valuation you'll have noticed that Google's discounted cash flow valuation depends heavily on where interest rates go in the future. If we use the treasury yield as the discount rate, then it's somewhere between fairly valued and undervalued depending on how much growth it can achieve. If we add a 6% risk premium to the treasury yield, then the stock is overvalued unless massive amounts of growth are achieved. The long-term treasury yield is the absolute lowest discount rate you can use in valuing a stock; the higher it goes, the less valuable stocks become, holding everything else constant. So, if the Fed resumes its rate hikes in order to fight energy inflation , Google will require ever more growth in order to be theoretically "worth it." However, high interest rates not only increase the hurdle that stocks' cash flows have to clear, they also tend to slow down the economy, so it's very unlikely that another round of Fed hiking will coincide with Google rallying.

• Regulatory risk: Google is subject to countless regulations worldwide, and sometimes it gets fined and/or sued when it violates them. Currently, it's appealing a $2.6 billion fine in the EU. The Department of Justice is also pursuing antitrust charges against the company. When companies get sued for antitrust, the resulting fines can be quite large, and sometimes the companies involved even have to spin off entire business units. So, regulatory risk is one for Google shareholders to watch.

The risks above merit being taken seriously. Nevertheless, Google has enough things going for it that it appears worth it overall. It has an excellent competitive position, it got its growth back last quarter, and it is the cheapest of its peers - there's a lot here to love. With most other mega cap tech stocks above 30 times earnings, Google looks like the best buy in its sector.

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