Alphabet Inc.'s  (GOOGL - Get Report)  fourth-quarter earnings revealed some blemishes. Nevertheless, Alphabet's performance overall was mostly positive. Consequently, I contend that any hiccups in Alphabet's results already have been more than priced in. Taken all together, I argue that Alphabet is currently undervalued.

Fourth-Quarter Recap

Alphabet's top line in the fourth quarter of 2018 was up 23% year over year at constant currency. However, outsized investments and acquisition costs led to Alphabet's operating income not keeping up with its top line and this was only up 7% to $8.2 billion.

At this point, it is important to step back and think about what we have just been told. On the one hand, Alphabet continues to post strong revenue growth, above 20% both for the year and for its latest quarter. But its share price hasn't moved over the past 12 months, which is quite remarkable.

One could make the argument that Alphabet's margins have compressed slightly to 21% from 24% during the same period a year ago, causing investors to be uneasy. However, I believe there is something else causing investors to remain uncertain over Alphabet's long-term prospects.

What Drives Alphabet's Prospects?

Alphabet is an advertising operation. In fact, 85% of Alphabet's total revenue is still derived from advertising. While this brings huge benefits, as it is asset-light and highly free cash flow generative, this also causes meaningful drawbacks.

One drawback is that it leaves Alphabet exposed to very concentrated risk in the event that advertisers found other cheaper alternatives that are equally engaging with its end users. Furthermore and possibly more meaningful, is that there is a limit to just how big advertisers' total addressable market actually is. And even more to the point, there is a limit to just how much advertisers would be willing to deploy via just one advertising platform.

Additionally, given the strong pace of growth which Inc.'s  (AMZN - Get Report) advertising operations are posting, some investors are starting to become fearful that Amazon will be as dominating in advertising as it has been with retail and the cloud.

Amazon lists its advertising revenue under its Other segment, and these operations reached 114% revenue growth in the fourth quarter - which sounds terrifying for Alphabet. However, once we start to put numbers to it we can see that Amazon's advertising business at roughly $10 billion is unworthy of causing substantial concern to Alphabet's $115 billion advertising business.

Then, separately, given the fact that Alphabet has long been cognizant of Amazon's encroachment into advertising, Alphabet continues to push hard to diversify into other avenues, such as Access (internet fiber), Verily (healthcare ) and Waymo (self-driving car project), to name just a few. The hope is that one of these emerging businesses opportunities launches Alphabet into its second era of growth.


As the table demonstrates, investor sentiment is firmly away from investing in tech companies at present. However, while many tech companies have seen their valuations justifiably correct during the past several months, I posit that Alphabet is not like other high-flying growth companies, which are continuously investing for growth but never actually generate any free cash flow.

In actuality, we can already see that in each of the past three years when Alphabet has generated somewhere between $21 billion to $25 billion of free cash flow. Note, these are not earnings, which need to be redeployed back into the business. This is cash, after all investment needs, which is slowly growing over time and is perhaps no wonder why Alphabet's net cash position has risen to close to $100 billion - accounting for just more than 13% of Alphabet's market cap being made up of cash.

Final Word

The best time to invest isn't when everyone knows the company is delivering strong results and the company is strongly in the limelight. On the contrary, the best time to invest is when a fallen angel loses favor with investors. The savviest investors are willing to wait for the right opportunity to be contrarian and above all have the patience to remain invested for two to three years in order to give enough time for positive investor sentiment to return to this extremely cash flow generative company. These shareholders which will benefit most.

Alphabet and Amazon are holdings in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells the stocks? Learn more now.

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I have no positions in any stocks mentioned.