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I usually like to submit detailed write-ups on undercovered, cheap small caps here. I’ve been doing a lot of primary research on two of my former submissions – footwear maker Crocs (CROX) and sporting goods retailer Academy Sports & Outdoors (ASO) – and I planned on updating one or both of them, but I just reviewed the rules on qualifying submissions and realized you can no longer resubmit on a previous idea. Those two are really my top ideas at this particular moment – particularly Crocs at the current quote – but I need to do something new here, so at the risk of choosing an idea that I might get totally roasted for submitting, I will offer some brief insights on a name that literally everyone who has ever invested has heard of and probably has an opinion on – Alphabet, aka Google.

There is obviously nothing I can tell you about Google that isn’t already known by someone somewhere. There is no rock to turn over here. There is only opinion about the size of its moat, how fast it will grow, valuation, and capital allocation. We are talking about a $1.75 trillion market cap company, the fourth largest in the world, with 65 sellside analysts covering it… there is not much I can tell you about its business ops that would be a revelation. There is a write up on here from March 14, 2022, submitted by member Kumiko, which summarizes the segments, shows the segment operating margins, outlines the aggressive share buybacks, and the high ROIC of the business. The numbers have grown and generally improved over the last 7 quarters, but nothing has materially changed here, other than the unleashing of a torrent of buzz about AI. This is still an extremely high margin business, with a giant competitive moat, which is extremely cash generative, has a big cash pile, and is aggressive about buying back stock.

I would say two major things have changed in the last year that are big positives for Alphabet:

1. In Q4 last year, there was a big panic about a macro slowdown. That was quickly followed by the Silicon Valley Bank crisis in the beginning of the year. Fears of a tougher economic environment made people jittery that the advertising market could crater and fears of a liquidity contagion ripping through the whole venture capital complex following SVB’s failure made people worry that cloud computing growth would slow materially. All of Big Tech had leaned into profligate spending after many fat years, and the drop in the stock prices of these companies in 2022 caused them to discover spending discipline, cut headcount, office space, and generally get cost conscious for the first time in a long time. The sense of existential urgency around cost cuts really kicked off at Meta Platforms (META) which saw EPS dip 38% in 2022 and its stock draw down 75% between 3Q21 and 4Q22. While the EPS declines and stock drawdown were more muted at Alphabet, it and its Big Tech peers saw what the market did to META shares and got out ahead of their costs into an uncertain 2023 operating environment.  As we all know, the dreaded recession never materialized in 2023, business was good, and in fact digital advertising – where Alphabet still makes virtually all its money – actually accelerated meaningfully from Q2 to Q3 this year and looks set to end the year strong. Cost cuts into growing revenue have translated into operating leverage. A bear would say margins look peak-ish. But an alternate take is that this is a company that hadn’t needed to have any spending discipline but has now found some.
2. 2023 will be remembered as the year that the TV/linear network ecosystem really started to unravel. What most media analysts had been anticipating for at least five years became a reality in 2023. Cord cutting built up to an inflection point where linear TV (broadcast and cable) revenues dropped high single to double digits (depending on the network/station/conglomerate and quarter you are looking at). With audiences declining, the reallocation of ad budgets from linear to digital channels accelerated. Linear networks could no longer offset audience contraction with CPM (pricing) increases. No doubt the interruption to new scripted content by the writers and actors strikes and the cancellation of the fall TV season did the industry no favors, and we could see some bounce in TV advertising when fresh content starts flowing back to the networks… but it does feel like the train has finally left the station on the crumbling of the linear TV advertising ecosystem. To get audiences – especially to get YOUNG audiences – advertisers increasingly need to go digital. This trend has been in place for over a decade, but it is accelerating now. The dollars from print and radio had long ago ported over to digital, but there is still a big fat pile of ad dollars going to TV and digital is going to cannibalize that in the coming years at an accelerating rate. And when dollars go digital, they overwhelmingly go to Alphabet and Meta. Alphabet’s YouTube has been, and will likely remain, the largest beneficiary of video ad dollars going from linear to digital. Even with the onslaught of advertising-supported video-on-demand services (AVOD), YouTube still offers the most scale for advertisers today, and it will be that way for the foreseeable future.

AI has also been a tremendous development over the last year and is causing an evolution in the digital advertising world in two ways. Generative AI is making it faster, easier, and cheaper to create different versions of creative concepts – creating images, changing colors, adjusting syntax on copy, etc. This is the part of AI that is newer. The other type of AI which impacts advertising is the machine learning component, which allows for better targeting of consumers online. This form of AI isn’t really new – it’s something that has been around and iterating and improving and evolving for years, but we are calling it AI now. Both are good things for Alphabet.

Generative AI has also been worked into search products, most famously in ChatGPT from OpenAI, which, via a corporate partnership, is available through Microsoft’s (MSFT) Bing search service. Google has a competing product called Bard. (More on this in a bit.)

Simply put, on any dimension you care to measure, Alphabet’s business is top notch. Alphabet’s competitive moat with Google search and YouTube doesn’t really require explanation. Its corporate operating margins in the high 20%s are twice that of the average stock in the S&P 500. It has $120 billion in cash and equivalents on its balance sheet, which gives it outstanding financial stability as well as the flexibility to keep buying back stock, propelling future EPS growth.

Despite these superior characteristics, Alphabet trades at a P/E ratio of around 24, only a slight premium to the 21.5x (on 2023 estimated earnings) that the S&P 500 trades at. I would argue that Google on every measure – financial stability, ROIC, margins, growth outlook, competitive positioning, capital discipline, etc. – is more than 12% superior to the average stock in the S&P 500. Alphabet is expected to grow its earnings 50% faster than the S&P 500 next year, with twice the operating margin. And if you adjusted its stock price to back out its cash holdings, Alphabet trades in line with the S&P 500 despite having a much higher profit margin and an incredibly deep competitive moat, particularly in the core search business where Alphabet still sources the majority of its earnings.

I think most of us as value investors take pride in finding an investment that is hard and figuring out something no one else has figured out. Some kind of undercovered small cap cash gusher, a company about to do a spin or make a transformative acquisition, a regulatory arbitrage, a management team that is incentivized to get a stock up by a certain expiration date. There is a certain pride of discovery in rooting out the obscure… but sometimes it doesn’t need to be that hard. As the great Warren Buffett famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Alphabet is very much a wonderful company at a fair price.

One of the key reasons most investors would object to buying Alphabet here is that it closed up 58% in 2023. I agree – that is a turn off for me as well. But it’s important to remember that GOOGL shares were down 39% in 2022, so GOOGL shares closed 2023 at a price that was 3.5% lower than where they were at the end of 2021. EPS in 2023 will be up roughly 2% versus 2021 (after dipping 19% in 2022). So despite the optics of a big price gain in 2023, Alphabet has been basically flat in stock price and in EPS over the last two years.

Much has been written about the outperformance of the Magnificent Seven this year – consisting of Alphabet, along with Big Tech peers Amazon (AMZN), Apple (AAPL), Meta, Microsoft, Nvidia (NVDA), and Tesla (TSLA). The group was collectively responsible for about three-quarters of the move in the S&P 500 this year, led by the 239% move in Nvidia and 194% move in Meta. Alphabet was a relative snoozer up 58%.

Many people are talking about the Magnificent Seven’s run being over with 2023, but I think it is lazy and a mistake to treat the group like a monolith. Consider that the individual members of the Magnificent Seven sport vastly different valuations. Tesla – arguably the constituent with the smallest competitive moat and most competition in the group - sports a P/E ratio of 80 and ecommerce and cloud giant Amazon sports a P/E just under 60 (on a single digit EBIT margin for the consolidated business). As noted above, Alphabet is trading at a market multiple, adjusted for cash. Some members of the Magnificent Seven are indeed very expensive after their big moves. Alphabet is not one of them.

I would rather own Alphabet than the average stock in the S&P 500 at this valuation, given its superior growth, margins, competitive position, and balance sheet characteristics. It’s an admittedly simple thesis, but that doesn’t be mean it’s wrong.

While the price of entry will be set for the day of idea submission because that’s the way VIC works, I would offer the following advice for entering or adding to Alphabet shares, given the recent run: wait for the inevitable swoon. Twice this year, the stock has toppled 10% or more on an overreaction. The first instance was when Google’s AI Chatbot Bard was initially released in February and it made a factual error in a demo, and there was a panic that Google was far behind Microsoft in AI and would lose share in search as a result. The stock went from $108 to $89 in three weeks on the panic. It recovered that dip within six weeks, and is sitting now at $139.69, 57% higher than those February lows.

Another buying opportunity came with the third quarter earnings report. Even though advertising revenue growth in both search (from 5% to 11%) and YouTube (from 4% to 12%) had accelerated meaningfully from Q2 to Q3, the market sold off GOOGL shares because growth in the cloud division came up short at 22% versus expectations of 27%. This is where being a value investor comes in handy when looking at this kind of stock. Growth investors sold off the revenue shortfall (in a division where Google barely makes any money) and ignored the acceleration of business in the division that is a cash cow. And for a value investor used to picking through piles of no growth or cyclical companies, 22% growth in anything is a straight up dream, even if that 22% misses a slightly higher bogey arbitrarily set by the sellside and growth investors. We know that “only” 22% growth is not the sign of a business in collapse. On that sell-off in October, GOOGL shares dipped from $139 to $122, and recovered that swoon within eight weeks and went on to end the year 1% higher than the price going into the Q3 report.

At some point, people will freak out over something, and that is when you buy this compounder.

Of course there is much macro uncertainty, and a possibly weaker economy in 2024 threatens to slow growth at both Google’s advertising businesses (search, YouTube, and display) as well in its cloud division. But despite all the rumblings about the economy, advertising growth accelerated meaningfully from the second to the third quarter at Google (as well as at Meta). And if advertising does eventually slow at some point in the future, Google search is probably the most mission critical and efficient way that big advertisers spend their money, so search is likely to take the smallest hit in a downturn, relative to other media channels like TV, social media, and programmatic advertising.

In good times and in bad, digital advertising continues to benefit from the shift of advertising budgets from linear to digital channels, a trend that has benefitted Google search and YouTube for years… and this digital migration of advertising dollars is only accelerating. An added benefit for Alphabet's prospects is that the swoon in Big Tech last year has made Alphabet, and all of its peers, more focused on managing costs, which is bullish for getting operating leverage on future revenue growth. GOOGL shares are a buy and hold for years to come. A true compounder at a reasonable price.

Risks:

• Regulatory – Extremely high market share in search has and will continue to attract the scrutiny of global antitrust regulators.
• AI – AI could prompt the loss of market share in the search business if Bard fails to perform at a similar level to ChatGPT or other competitors. It’s reassuring to see that despite all the noise earlier this year, Bing has not taken any share from Google Search despite its head start with ChatGPT.
• Return of excessive opex growth– I think the PTSD from the stock swoon in 2022 should stick with management for a few years at least.
• Other Bets – Alphabet loses $4 to $5 billion annually in this division that invests in new businesses. These businesses range from start-up/R&D phase to commercialized but loss-making and include Waymo, Google Health, and Google Fiber. Exploring these new tech areas is core to the ethos of Google and its tech talent, so this spending line is unlikely to ever go away. The risk is that it could ramp higher (but I am not too worried about this).

Catalyst

1. Acceleration of the reallocation of ad budgets from TV to digital
2. New found cost discipline should lead to operating margin expansion over the next 2 years
3. In the very short-term, the long period/more days between Thanksgiving and Christmas led to a longer shopping season and should be good for Q4 revenues in the ad businesses