Description

Note: While my broader thesis is below, I want to highlight the three reasons I believe this company will appreciate sharply (+100-160% to $2,200-$2,900/share) from current prices:

1. Android is the single largest and most important “hidden asset” in the world.  At present, it is only monetized indirectly through Play Store purchases. GOOG is going to, for the first time, begin charging smartphone manufacturers to pre-install Play Store, Gmail, YouTube and Maps via one license, and Search and Chrome browser through a second license, on its European phones.  Ostensibly, this is to comply with European regulators and replace potentially lost ad revenue, but let's be realistic - every manufacturer is going to have to buy these licenses if they want to sell their phones.  https://www.nytimes.com/2018/10/16/technology/google-android-europe-apps.html

1. Android has more than 2 billion monthly active devices and about 1.2 billion are sold annually right now.  https://www.statista.com/statistics/266219/global-smartphone-sales-since-1st-quarter-2009-by-operating-system/

2. I could easily see GOOG adopting this new charge for pre-install policy globally, after all, in July, Sundar said they may begin charging for Android, writing "So far, the Android business model has meant we haven't had to charge phone makers for our technology, or depend on a tightly controlled distribution model." https://www.blog.google/around-the-globe/google-europe/android-has-created-more-choice-not-less/  

3. If this policy becomes a backdoor way to charge for Android, and say GOOG were to charge $5-10 per device for these pre-installs, on 1.2 billion device sales annually that works out to $6-12 billion, which would essentially be 100% incremental pre-tax cash flow.

4. This may even be conservative, as Google management has been thinking of this as a recurring revenue stream on the full base of users.  In 2010, Eric Schmidt said “If we have a billion people using Android, you think we can’t make money from that?” and said all it would take is $10 per user per year.  With 2 billion current users, that would be a $20 billion annual cash flow stream. https://blogs.wsj.com/digits/2010/07/28/eric-schmidt-on-google%E2%80%99s-next-tricks/

2. YouTube is probably the best (and most widely loved) business in the world, and eventually probably becomes worth more than the current enterprise value of Alphabet.  Google Maps and Waymo may turn out to be second and third over time, but we're not paying for that now.

3. If Alphabet were ever to separate into 3, 4, 5 or more pieces, I believe the equity value creation would be both instantaneous and massive. The market is making a big mistake by treating break-up headlines negatively.

***

Alphabet Inc. (Nasdaq: GOOG, www.abc.xyz/investor):  

Based in Mountain View, CA, Alphabet Inc. (“Alphabet”) is the ubiquitous Internet and software platform company.  The company reports in two segments: (i) Google, which consists of the company’s core products and platforms, each of which has over 1 billion monthly active users, and (ii) Other Bets, a diverse collection of early-stage businesses, several of which are revenue generative yet cash flow negative.  While the company is obviously well-known and widely covered, I believe it is severely underappreciated and often misunderstood. Below, I attempt to distill the company’s primary assets and businesses.

Google

1. Google Search, the dominant global Internet search engine and #1 ranked global website.

2. Google AdWords, the online advertising platform that allows advertisers to pay per user action to display product listings and video content within the Google network to web users.  AdWords is Alphabet’s primary source of revenue.

3. Google AdSense, the technology platform with nearly 2 million users that allows publishers in the Google Network of content sites to serve automated advertisements that are targeted to site content and audience.

4. Android, the mobile operating system acquired by Google in 2005 for an estimated $50 million, presently with 2+ billion monthly active users and the largest installed base of any operating system, equating to an estimated 85% global smartphone market share.  In addition to smartphone and tablet use cases, the platform has been extended to Android TV, Android Auto and Android Wear.

5. YouTube, the dominant global Internet video platform acquired by Google in 2006 for $1.65 billion, presently the #2 ranked global website.  Provides (i) ad-supported video for free, (ii) ad-free premium subscriptions via YouTube Premium, and (iii) a subscription-based virtual MVPD via YouTube TV.  YouTube content creators have an opportunity to share in revenue generation. Presently, YouTube has 1.5 billion monthly logged-in users and 1 billion daily hours of watch time.

6. Google Maps, the dominant web mapping service, including satellite and space imaging via Earth, street maps and panoramic images via Street View, real-time traffic conditions via Traffic, route planning for travel by car, foot, public transportation or bicycle.

7. Google Play, a digital distribution service that serves as the official app store for the Android operating system as well as offerings under the Google Play Books, Google Play Games, Google Play Movies & TV, Google Play Music and Google Play Newsstand banners.

8. Google for Education, which streamlines assignments, fosters collaboration and communication in both K-12 and higher education.  The Chromebook’s recent overtaking of Apple's iPad is detailed in the 2017 New York Times article “How Google Took Over the Classroom.”

9. Chrome, which includes the leading Internet browser for desktop and mobile applications, the Chrome operating system for Chromebooks and Chromecast for streaming entertainment.

10. Gmail, a free ad-supported or paid subscription ad-free email service with an estimated 1.2 billion active worldwide users.

11. Google Cloud Platform, a suite of cloud computing services that runs on the same infrastructure that Google uses internally, providing services including cloud computing, data storage, data analytics and machine learning to third party organizations.  GCP is the third-largest (to Amazon Web Services and Microsoft Azure), and fastest-growing, public cloud platform. The G Suite productivity platform, including Gmail, Docs, Drive, Calendar, and Hangouts, is the sole legitimate competitor to Microsoft’s Office productivity suite.

12. Hardware, Google’s line of branded products including the Google Home voice assistants, Pixel smartphones, Pixelbook laptops, Daydream virtual reality gear and Nest connected home devices.

Other Bets

1. Waymo, a self-driving technology company that has self-driven more than 5 million miles, mostly on city streets, plus over 2.7 billion miles driven in simulation in 2017 alone.

2. Nest connected home products, including thermostats, security cameras, locks, doorbells and alarm systems (merged into Google Hardware segment in 2018).

3. Verily, a life sciences company which received an $800 million investment in 2017 from Temasek, focused on developing tools and platforms to enable continuous health data collection for timely decision-making and effective interventions.

4. Access, which houses Google Fiber.

5. Calico, a company devoted to understanding the biology that controls lifespan.

6. CapitalG, formerly Google Capital, Alphabet’s internal growth equity investment arm that holds equity stakes in companies including Lyft and Airbnb.

7. GV, formerly Google Ventures, Alphabet’s internal venture capital arm that holds equity stakes in companies including Flatiron Health and Uber.

8. X, which is Alphabet’s self-described “moonshot factory,” including projects in balloon-powered Internet, cybersecurity, alternative fuels and energy storage.

Keys to my thesis include:

• Intersection of Strong Secular Trends.  Alphabet’s businesses are supported by powerful, global tailwinds of expanding high-speed Internet access and accelerating broadband speeds, driving the proliferation of web usage, data and content creation, digital advertising, mobile computing, streaming entertainment, and public cloud software and computing platforms. Alphabet sits squarely at the center of each of these trends, and as the established leader is best positioned to capitalize on the winner-take-most dynamic associated with platforms and networks, including in the hiring/retention of talent and acquisition of emerging technologies.

• A Force for Good (notwithstanding headlines from old media).  While concerns about data collection policies are in the headlines, I believe Alphabet’s products and services are a distinct net positive for society.  No other company, in my opinion, does more to make learning, information access or daily life activities easier or more efficient for more people around the world.  The company is far from perfect, however management has exhibited a desire to continue improving the company’s platforms, products and services.  I believe strongly in privacy and personal freedom; however, I have happily opted in to share certain personal data with Alphabet because it makes my life easier and I believe the company employs the strongest security safeguards readily available.

• Failed Competitors.  There have been numerous would-be competitors that have each invested billions of dollars to compete with Alphabet’s various platforms, and failed.  This is true in search, mobile operating systems, video, education, maps, email, web browsers, voice assistants and autonomous driving. Further, Alphabet has a history of coming from behind and overtaking other competitors with superior technology, and there is evidence this may now be starting in cloud, hardware and travel, where Alphabet is likely the fastest grower in each of these three industries.

• Ecosystem/Virtuous Cycles.  Consumers and developers alike generally love Alphabet’s products and services, creating a virtuous cycle of increased platform value and consumer usage (this mirrors the “ecosystem” thesis many have applied to Apple, however Alphabet is truly a software company, while Apple is nearly wholly dependent on hardware sales).  I am personally a substantial consumer of Alphabet’s products and services, and in the last 18 months have purchased the following: (i) two subscriptions to YouTube Premium, (ii) two subscriptions to Google Play Music, (iii) one Google Pixel 2 smartphone and one Google Pixel 3 smartphone, (iv) one Chromebook and one Pixelbook, (v) four Google Home devices, (vi) two Nest thermostats, (vii) four Nest Cam IQs and (viii) one Xiaomi Mi Box S 4K for Android TV.  In addition, I installed Android Auto (which is awesome) in my car for Google Maps, real-time navigation and unlimited streaming music (displacing SiriusXM’s music and navigation system). I cut the cord on Charter and became a YouTube TV subscriber. And at work, I am a happy G Suite business customer (works very well with Microsoft Office 365).

• YouTube Juggernaut.  I believe YouTube may prove to be the most valuable and durable Internet platform in history.  It is difficult to imagine another company emerging to challenge YouTube given the network effects of its platform at scale.  In July 2017, Netflix CEO Reed Hastings said, “Again, I’m not sure we are leading [the Internet video market] when you look how far ahead YouTube is” and wrote in his shareholder letter “YouTube is earning over a billion hours a day of consumers’ time…while we are earning over a billion hours a week…” Three months earlier, he said “Our viewing is very large and growing, but nowhere near as big as YouTube’s, so we’ve definitely got YouTube envy and we’ve got a lot of room to go.” Netflix has an inferior business model in which it must pay prodigious sums to purchase or produce video content that may or may not be popular with subscribers, while YouTube is essentially a pure technology platform where creators provide the content and meritoriously share in advertising and subscription (YouTube Premium) revenue generated.  For perspective, Netflix presently has an enterprise value of approximately $150 billion. While we do not yet have YouTube financial data, the SEC has been asking questions about the lack of disclosure, and I believe it is possible that this division alone could be worth multiples of Netflix in the next several years.

• Next-generation Transportation Dominance.  Alphabet seems likely to become the dominant transportation platform, with Waymo’s self-driving technology being the clear leader in its field, Maps being the dominant platform for location and real-time traffic and routing, and YouTube the dominant platform for in-car entertainment.  The Atlantic published a 2017 article regarding Waymo that is instructive and this blog post regarding Google Maps’ massive lead over Apple is outstanding.  The licensing potential for Waymo’s technology appears to be substantial.

• Misunderstood.  The company is often erroneously described in parallel with Facebook or grouped in as a “FANG” with Amazon and Netflix.  While both Facebook and Alphabet generate advertising revenue, in my view the relevant comparison stops there, while the contrasts are stark.  At the risk of oversimplifying, I would argue that Facebook essentially consists only of two photo-sharing apps (Facebook and Instagram, the latter of which appears to be cannibalizing the former) and two messaging apps (Facebook and WhatsApp).  Further, I consider Facebook a bit of a black box given its association with fake users, fake likes and click farms. Amazon’s leading cloud computing business funds its capital and labor intensive, lower-margin retail/logistics business.  Netflix is presently a highly cash-destructive content business highly dependent on the capital markets, which I believe is incomparably inferior to YouTube.

• Outstanding, soft-spoken leadership from Sundar Pichai (Google CEO), Ruth Porat (CFO), Susan Wojcicki (YouTube CEO), John Krafcik (Waymo CEO) and Thomas Kurian (Google Cloud CEO).  In addition to being extraordinarily accomplished, each of these executives individually strikes the right tone of modesty and awareness in a highly politicized environment for the large technology companies. While founders Larry Page and Sergey Brin remain in control, the day-to-day leadership appears best-in-class.

Net of cash and marketable securities, Alphabet’s enterprise value is approximately $663 billion.  I estimate 2020 Core EBIT (excluding losses from Other Bets and stock-based compensation) of nearly $60 billion, implying a current EV/2020 Core EBIT multiple of about 11x.  On a forward-looking basis, I believe it is conservative to value the core business at a market P/E of approximately 20x and add reasonable estimates for value for significant profit-non-contributory assets including YouTube (>$200bn), Cloud (~$100bn), Waymo (~$100bn), Maps (~$25bn), Travel (~$25bn), Hardware (~$25bn) and Verily/Fiber/Calico/VC Investments/Moonshots (~$25bn).  On this basis, I estimate the Core business plus ~$100bn of excess cash to be worth over $1,500 per share, while significant profit-non-contributory assets are likely worth at least $500bn, or >$700 per share, creating an implied value of over $2,200 per share.  Further, as I noted in the introduction, it is important to note that Android is essentially unmonetized as an operating system beyond Google Play Store app revenue, which is shared with third party app developers.  Should Android ever be monetized in a manner similar to either Microsoft Windows (i.e. via license fees charged to device manufacturers) or Apple iOS (i.e. via a large, high margin hardware business), the incremental profit potential with 2+ billion global users is enormous.  Per Eric Schmidt’s mental model of $10/Android user/year, an incremental $20 billion cash flow stream might be worth another $500 billion at 25x, or $700 per share. Total value for Alphabet shares may be over $2,900 under an explicit Android monetization scenario implied as possible by both Schmidt and Pichai.

Regulatory risk is often discussed with respect to Alphabet, however I am less concerned about this as I believe if the company were broken up, investors would be forced to value each of its businesses separately with full transparency, which I believe would result in a sharp, upward re-valuation. After all, even Donald Trump recently called Google "one of our great companies"!

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Please do your own research.

Catalyst

YouTube and Cloud financial disclosure
Awareness of Android value realization potential
Break-up realizing full SOTP