It might seem like there’s a lot to the Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG) stock price. After all, Alphabet has a hardware business, including its Pixel phone, Google Home, and Nest. It has a venture capital arm: Google Ventures. There’s also their self-driving startup Waymo. Alphabet has a cloud business, too. It would seem as if there’s a lot to keep track of when it comes to Alphabet stock.
But that’s really not the case. GOOGL still relies heavily on the search business on which it was based at the time of its founding, 20 years ago next month. The other businesses are interesting and get some media coverage. But even Waymo — likely the most valuable of the company’s non-advertising efforts — accounts for only a modest fraction of the overall value here.
That’s one of the reasons I’ve long been relatively bearish toward Alphabet stock. The ad business has been a juggernaut, to be sure. But there are risks ahead. The continuing shift to mobile phones was one of the reasons the GOOGL stock price saw pressure earlier this decade. Alphabet obviously has adapted, but higher usage of apps — and less usage of Google browsers — creates a similar risk going forward.
Even with those concerns, however, I’ll admit that Alphabet stock is getting interesting. Q2 earnings looked quite strong on the advertising front, even if they weren’t quite as amazing as headline numbers seemed to show. The GOOGL stock price suggests a reasonable valuation for that underlying business. And there is some value in the non-advertising initiatives.
I’m not quite ready to dismiss the risks altogether. But after 18 months of sideways trading, GOOGL stock is getting awfully cheap.
The Good and Bad From Q2 Earnings
On its face, Alphabet’s Q2 looks like a monster quarter. Adjusted EPS came in at $14.21 — $2.91 above the Refinitiv estimate. The figure grew a healthy 21% year-over-year.
But it’s important to remember that, as I’ve written before, Alphabet earnings are somewhat tricky. Thanks to a recent accounting change, the company can book a profit or a loss on equity securities it holds. In Q2, that gain was $2.7 billion — up over $1.6 billion year-over-year. At least some of the spike likely came from the IPO of CrowdStrike Holdings (NASDAQ:CRWD), in which Alphabet booked a reported $1 billion-plus profit.
Backing out those gains, the news is good — but not quite that good. Adjusted operating income (which backs out last year’s $5 billion fine by the European Commission) rose 13%. Margins actually compressed year-over-year, raising continued worries about the company’s ever-increasing spending.
Of course, investors also should back out losses in the company’s “Other Bets” businesses — where Google is investing now for profits later. Excluding those losses, the core business grew operating income 15%, but margins still compressed.
The reaction to the report makes some sense. The GOOGL stock price soared after a report that looked like a monster beat. Given time to digest the results, investors sold the news, as the quarter wasn’t quite as strong as it first appeared. But it’s that pullback — and this understanding of the core business — that makes GOOGL stock quite interesting at current levels.
The Case for Alphabet Stock
Alphabet closed the second quarter with a whopping $117 billion in net cash on its books. That’s roughly $167 per diluted share, or about one-seventh of the company’s current market capitalization.
Operating earnings so far this year have been $15.8 billion — but that includes $1.86 billion in Other Bets losses and an additional fine from the EC of $1.7 billion. Add those back, and underlying, full-year, operating earnings should reach roughly $39 billion in 2019.
At a 22% tax rate (Alphabet’s rate bounces around from quarter to quarter), that’s over $30 billion in net income — or about $43.50 per share. Deduct the $167 in cash from Tuesday’s close (the GOOGL stock price, not GOOG) of $1,171, and Alphabet stock is trading at about 23x its earnings power.
That’s about in line with Facebook (NASDAQ:FB), which makes sense given the two companies’ dominance in online advertising and their regulatory risks.
But even that might understate the case somewhat. There’s value in the Other Bets business. Most notably, Waymo has been valued at $175 billion by Morgan Stanley (NYSE:MS).
It’s not terribly difficult to make the case that Alphabet stock values the operating business — and investors at this price get Waymo for free. If Morgan Stanley’s estimate is correct, or close, that suggests roughly 20% upside in GOOGL from here. For what it’s worth, that would roughly get the stock to the average Wall Street target, which currently sits at $1,369.
Advertising Will Drive the GOOGL Stock Price
That model, however, requires that the advertising business do the heavy lifting. Even Waymo, at Morgan Stanley’s hefty valuation, accounts for barely 20% of the current market capitalization and less than that at a $1,300+ share price.
Google hasn’t been great in hardware, where it has lost steadily to the likes of Roku (NASDAQ:ROKU) and even NETGEAR (NASDAQ:NTGR), let alone Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL). Fiber has been somewhat of a disappointment. Capital G is making profits — but it’s not going to make billions of dollars a year every year. Cloud growth was a bright spot in Q2, but at a run-rate of $8 billion annually, drives barely 5% of total revenue.
And there are real risks to the advertising business. The Android OS makes quite a bit of profit from Google Play — but companies like Netflix (NASDAQ:NFLX) are trying to work around Play and the Apple App Store. Google’s revenues in search are rising; it’s traffic acquisition costs generally have risen faster, though that trend stopped in Q2 (that’s one reason, beyond the headlines, I saw the quarter as a positive).
Even the Q1 miss Alphabet posted is a concern. Alphabet never really explained what happened and largely refused to do so when asked on the Q2 conference call. As good as the business has been, there are questions as to whether it will be that good going forward — or at least good enough to support a $500 billion-plus enterprise value (backing out cash and the value of Waymo).
This is a stock that has traded sideways for a good eighteen months. Over that stretch, underlying earnings have grown — which means GOOGL stock has gotten cheaper. Whether it’s cheap enough depends on whether advertising profit growth can continue. Q2 certainly helps on that front.
As of this writing, Vince Martin is long shares of NETGEAR. He has no positions in any other securities mentioned.
