Alphabet (GOOGL) - Get Report has lost more than 25% of its valuation from its highs of just more than a month ago. And in a sea of chaos backed with indiscriminate selling, investors are throwing the baby out with the bathwater.
Investors Panic Amid Uncertainty
At the end of a very long bull market, investors were hoping for an easy time and for the steam to slowly fade down - but that didn’t happen!
Even though the government has put in place positive measures to uphold businesses during the coronavirus pandemic, the aftermath of temporarily closing down the economy is leaving investors with huge uncertainty. How long will this global recession last? How deep will it be? Will it quickly rebound? At this moment, investors have more questions than answers.
True North: Buying Amazing Companies
It is impossible to predict the unpredictable, such as knowing where the stock market will finish in 2020. What is slightly easier is to have a vague understanding of where Alphabet’s valuation will be over the next two to three years. To this, the majority of investors will acknowledge that its valuation will be higher over the next several years than it is now. But the only question that investors are presently obsessing over is the wrong question - how much lower can Alphabet’s valuation go over the next several weeks?
Alphabet Holds Not Just One but Two of the Biggest Search Engines
Although YouTube is considered a social media platform, it is, in fact, a search engine. What’s more, YouTube is the second-biggest search engine behind Google.
Moreover, what investors appear to dismiss about YouTube is its ability to farm user data in ways that are totally unmatched by other competitors: what we like to eat, where we want to travel, what do we want to study, what are our hobbies and our real passions.
As investors, we can finally put some tangible numbers to YouTube’s business: $4.8 billion of revenue in the fourth quarter of 2019 and was still growing at more than 30% last quarter.
Put another way, YouTube was the second-biggest driver of total revenue and the second most visited website in the world, while accounting for nearly 15% of Alphabet’s total revenue.
Having said that, the concern on investors' minds is, of course, how will Alphabet’s advertising revenue be impacted in a global recession? Will brands still consider this premium company with its impressive reach indispensable? And even if it gets less impacted than other advertising peers, does it still get meaningfully impacted? And how long until ad spend rebounds?
These questions are crucial but unknowable. What is knowable is that Alphabet’s valuation has a large margin of safety, and herein we should focus.
Valuation - Huge Margin of Safety
Up until the coronavirus outbreak, notwithstanding its size, Alphabet was still growing at approximately 20%. Furthermore, Alphabet is unlike many of its ad peers that reported growth but lack a consistent ability to generate strong and stable free cash flows. Indeed, for every dollar in revenue, Alphabet is able to convert slightly more than 17 cents of clean free cash flow. Note that this is after substantial capital expenditure requirements.
Accordingly, with ample growth and strong cash flows, it is perhaps understandable why its balance sheet is so strong and carries close to $115 billion of net cash.
Looking back, over recent years there have been strong calls by shareholder groups for Alphabet to return more cash to shareholders. In a prescient move, Alphabet’s management opted for prudence rather than maximizing short-term performance. Today, with close to 15% of its market cap made up of cash, that cash will be hugely valuable.
The Bottom Line
In the throes of investor panic, Alphabet is a strong free cash flow generator with strong revenue growth. Even if the next couple of quarters will be challenging, once the economy rebounds Alphabet should outperform many of its peers.
Investors would do well to consider this investment opportunity.