GOOGL | 1 Analysts Ryan Crockett [email protected]Nicholas Payne [email protected]Maxwell Neumann [email protected]Trevor Heimke [email protected]Company Overview Alphabet Inc. (GOOGL) is the contemporary goliath of innovation and advertising powerhouse of the Internet Software & Services industry. It was founded in 1998, headquartered in Mountain View, California. Originally providing just a search engine, Alphabet now holds 8 distinct subsidiaries specializing from anti-aging research labs to self-driving cars. As a company, they focus mainly on cultivating creativity and solving large problems. Implementing a “what if” attitude has allowed Alphabet to become the second largest publicly traded company in the world with an attractive future. Stock Performance Highlights 52 week High $810.35 52 week Low $529 Beta Value 0.908 Average Daily Volume 2.48 m Share Highlights Market Capitalization $531.32b Shares Outstanding 1.77 b Book Value per share $175.07 EPS $23.59 P/E Ratio 32.72 Dividend Yield 0.0% Dividend Payout Ratio 0.0% Company Performance Highlights ROA 11.74% ROE 14.54% Sales $73,590b Financial Ratios Current Ratio 4.67 Debt to Equity 4.34% One Year Stock Performance Continuing to Find Innovation in Desolation Google advertising revenues will continue to expand with the economy at a stable pace. Costs of Revenues will simultaneously increase at a decelerating rate with system innovation. Revenues coming from sources other than advertising (Google Other Revenues) will start to make up a more significant percentage of total revenues. Expect Research & Development costs to continue to climb as Alphabet extends into research intensive ventures. Production of driverless cars will require Alphabet to greatly increase their capital expenditures or will involve rapid expansion with more operating lease expenses. Anticipate a large surge within the next three fiscal years. Liquidation/ Sale of Yahoo will prove beneficial for Google revenues as they pick up the deterred market share in the next fiscal year. Nest & Other hardware sells will begin to show more promise as workforce restructuring reinvigorates product line. Previous sales failed to make an impact on overall revenues, future performance will not reflect on past numbers. Alphabet Inc. (NASDAQ: GOOGL) Current Price: $751.72 Target Price: $843.94 Technology Krause Fund Research | Spring 2016 Recommendation: BUY April 13, 2016
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Alphabet Inc. (NASDAQ: GOOGL) Recommendation: BUY April 13, … · cultivating creativity and solving large problems. Implementing a “what if” attitude has allowed Alphabet to
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Company Overview Alphabet Inc. (GOOGL) is the contemporary goliath of innovation and advertising powerhouse of the Internet Software & Services industry. It was founded in 1998, headquartered in Mountain View, California. Originally providing just a search engine, Alphabet now holds 8 distinct subsidiaries specializing from anti-aging research labs to self-driving cars. As a company, they focus mainly on cultivating creativity and solving large problems. Implementing a “what if” attitude has allowed Alphabet to become the second largest publicly traded company in the world with an attractive future. Stock Performance Highlights 52 week High $810.35 52 week Low $529 Beta Value 0.908 Average Daily Volume 2.48 m Share Highlights Market Capitalization $531.32b Shares Outstanding 1.77 b Book Value per share $175.07 EPS $23.59 P/E Ratio 32.72 Dividend Yield 0.0% Dividend Payout Ratio 0.0% Company Performance Highlights ROA 11.74% ROE 14.54% Sales $73,590b Financial Ratios Current Ratio 4.67 Debt to Equity 4.34%
One Year Stock Performance
Continuing to Find Innovation in Desolation
Google advertising revenues will continue to expand with the economy at a stable pace. Costs of Revenues will simultaneously increase at a decelerating rate with system innovation. Revenues coming from sources other than advertising (Google Other Revenues) will start to make up a more significant percentage of total revenues. Expect Research & Development costs to continue to climb as Alphabet extends into research intensive ventures. Production of driverless cars will require Alphabet to greatly increase their capital expenditures or will involve rapid expansion with more operating lease expenses. Anticipate a large surge within the next three fiscal years. Liquidation/ Sale of Yahoo will prove beneficial for Google revenues as they pick up the deterred market share in the next fiscal year.
Nest & Other hardware sells will begin to show more promise as workforce restructuring reinvigorates product line. Previous sales failed to make an impact on overall revenues, future performance will not reflect on past numbers.
Alphabet Inc. (NASDAQ: GOOGL) Current Price: $751.72 Target Price: $843.94
Technology Krause Fund Research | Spring 2016
Recommendation: BUY April 13, 2016
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Executive Summary For Alphabet Inc. our team of analysts suggests a BUY rating. The current share price is trading at $751.72 but we believe this is below the true intrinsic value of the stock. The Discounted Cash Flow and Economic Profit valuations yielded the most accurate forecasted share price at $843.94. This price was then adjusted to reflect partial year expired. Other valuations such as the Dividend Discount Model and the Relative Valuations yielded values below current day trading prices and we believe they should not be used when issuing a decision. We believe these models should be discredited because Alphabet Inc. is drastically different than any other company that currently exists. Since the DDM uses industry average metrics and the Relative Valuation is compared to other similar companies, it is hard to trust the accuracy of these results. Furthermore, we expect Alphabet to continue developing and producing new technology that will have large initial costs but will create new long-term sources of revenue.
Economic Outlook
Real Gross Domestic Product
Real Gross Domestic Product for the United States experienced an increase at an annualized rate of 2.4 percent in 2015 after the third revised estimate. After these revisions, we have increased at the same rate as 2014.1This increase signals a healthy economy, but plateauing from the previous year hints at near future uncertainty and should be handled with caution. Revenues brought in from Google are heavily reliant on advertising. As a top company in the massive online advertising industry, GDP growth is a fair indicator of the direction Google trends. Corporate profits decreased by 159.6 billion in Q4 of 2015, compared to
a 33 billion decrease in Q3 of the same year.2 Alphabet still managed to have an impressive growth despite the large downfall in corporate profits.
The Personal Consumption Expenditures index slowed down to a 1.1 Q4 increase in comparison to an increase of 2.2 percent in the previous quarter.3 The deceleration in PCE is likely heavily contributed to the slowdown of GDP growth. PCE is necessary to monitor for the rough estimates of disposable income of consumers. According to the Federal Reserve, PCE inflation is expected to rise significantly in 2016. This is most likely attributable to the plans to gradually increase interest rates and the proposed inflation target of 2%. 4
Another factor which could drastically effect the Real GDP is the impact of the presidential candidacy. The Treasury Department in April of 2016 implemented tighter restrictions on corporate taxation rules. Details in this imposed change mean tax inversions have less benefits towards earnings stripping and make accessing foreign profits more difficult.5 New regulations are expected to lower corporate profits for international conglomerates, negatively effecting GDP.
The capital markets started the year off with substantial volatility. Significant positive correlation with oil prices in combination with the poor economic strategizing announcement from the Federal Reserve are likely reasons for this. Near the end of Q1, the markets have gained momentum and oil stagnation has smoothed. We anticipate at least one rate increase this year, rising to .75% and a supporting short term GDP growth of 2.2% in 2016. In the longer horizon, we expect the U.S. to increase GDP growth to an annualized rate of 2.6%, contingent on the implied independence between capital markets and oil prices.
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Consumer Confidence & Sentiment Index
Consumer confidence is a survey put out by the Conference Board that measures the attitudes consumers have towards the economy. Surveyors answer questions about their current and potential future income, employment, and business conditions as a whole. Consumer sentiment is a survey conducted by The University of Michigan. This survey is very similar to the confidence survey, where both numbers are generally very similar to the other. This survey has questions geared toward the attitudes of the individuals towards the economy, and the strength of consumer spending. For Q1 in 2016, U of Michigan’s Consumer Sentiment stayed between the 91 – 95 range, slowly declining. April CSI came in at 89.7, which is lower than the expected 91, but is still a healthy number considering the recent political and macroeconomic growth conditions. 6 We want to keep a close watch on consumer confidence numbers to know what we can expect in revenues from Google Network Members. As confidence remains higher, inclinations to spend more money leads to higher online traffic, and a greater likeliness businesses will continue utilizing their web services. Minor fluctuations in Consumer Confidence will have little to no effect on traffic due to the immense amount of data Google has access to that isn’t related to financial spending habits.
Reports of a slowing in wage gains, inflationary adjusted income weakening, and political uncertainty as it pertains to the economy are contributing to the lower CSI readings. Previous consumer survey data remained extremely high despite more uncertain economic conditions, making this sub-90 rating partially admissible. Non- recessionary years average at a rating of 87.6, while the five recession periods averaged to 69.3; This signaling that we still have far to fall before adjusting.7
We believe that Consumer Confidence will decrease and hang slightly around 94 in the short term while Consumer Sentiment will hit 87.5. These numbers centered around the slight increases in employee compensations, the deteriorating income expectations and the assumption that oil will rebalance and rise in the capital markets. In the long term we anticipate the CCI to increase and stay around 97 and CSI to move back to 93.
Employment
Employment in the U.S. has continued to rise, showing the demand for a larger labor force while further ascertaining the strength of the job market as a whole. This hiring of employees can signal an expansive economy, as companies can afford to hire more workers. Hourly earnings have risen 2.3 percent through 2015, and non-farm payrolls have increased 215,000 – which was 5,000 higher than the consensus.8
Alphabet is known for being one of the most desirable companies to work for in the eyes of millennials and other top programming talent. That being said, they pay large premiums for the upper echelon of talent. Wage growth increasing at a steady rate could induce wage inflation in Alphabet’s corporate setting. Having an already high salary percentage with the expectations of growth may not bode well. In 2015 employment rose from the previous year as a whole, leaving less people without a job. This shows that companies are feeling confident in their operations and futures, as they are making the investment to hire new employees. We feel this is one signal of a strong economy.
The employment cost index (ECI) rose in the fourth quarter of 2015 by .6%. The ECI is a measure of employee wage growth in the United States. This measure is important to monitor because it is useful to
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interpret cost pressures that can have an impact on the inflation rate in the United States.9 The unemployment rate has held steady for year-end 2015, through March 2016 at 5%.10
The graph below shows that unemployment has continued to fall quarter after quarter for the last 2 years rather steadily. This could be because individuals are now more optimistic about finding a job, which can lead to a better performing economy, or because companies are looking to expand their operations and need new talent.
Bureau of Labor Statistics U.S. Department of Labor10
We feel that the economy is continuing to expand, which leads to an increase in employment. In the short-term (6 month outlook), we see the unemployment rate staying at 5%. In the long-term (2-3 year outlook), we see the unemployment rate dropping below 5%, to around 4.7%.
Our belief in this comes from the consumer confidence, which is at a high level right now, showing consumers are feeling positive about their financial future. For the technology sector, we can expect to see an increase in the amount of skilled labor workers getting jobs. The tech field is one of ever changing needs and increased innovation, which will be spurred on by the hiring of new employees.
The technology field is comprised of many successful companies, which leads to cut-throat competition between them, like Apple and Google. One of the best ways for companies to stay innovative is to hire new people who will in turn bring with them new ideas.
Exchange Rates
The exchange rate is the price of a nation's currency in terms of another currency.11 For simplicity, we will be analyzing current exchange rates using the US dollar, as a base currency. Analyzing current exchange rates plays an important role in the technology sector mainly due to the large amount of sales from foreign markets. There has been a notable correlation between the strength of the US dollar and US technology performance. The graph below shows that when the US is dollar is weak, technology performance tends to excel due to foreign buyers having more confidence in the US market.12
Fisher Investments on Technology pg. 56-57
Conversely, there are also benefits for US industries when the US dollar is strong. Products imported from foreign markets will be cheaper to US corporations resulting in lower costs. Companies who have more imports than exports in times of a strong US dollar will benefit more than those who don't.13
Source: Federal Reserve14
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Source: FactSet
Due to recent decline of production recorded by the Purchasing Managers Index (PMI) manufacturing report, we estimate the Trade Weighted US dollar Index to increase to 130 in the next 6 months. However, we predict the Trade Weighted US dollar Index to fall between 100-105 in the next 2-3 years. We believe the main reason for this long-term Trade Weighted US Dollar Index decline is the US export estimates to increase over the next two years.21
We expect Google will benefit from a slight decline in the value of the US dollar due to the importance of foreign revenue for Technology based companies.
Capital Markets Outlook
The technology industry as a whole has performed very well over 2015 (3.39% return from S&P 500 Information Technology Sector), and we see this continuing on into the future. With the increase in online traffic, companies that provide online services are benefitting from more advertising to a broader range of consumers, enhanced developments in the specific technology hardware, and the increases in online sales.22
We feel this is a good time to invest in the internet software and services sector of the tech industry. Alphabet just announced a phenomenal beat on revenue expectations (increase of 18%) as well as beating the expected EPS of 8.09 (actual of 8.67).23 Alphabet is an anchor for the industry, weighted at 54.36% of internet Software and services and 20.65% of the Technology industry as a whole.24
A company similar to Alphabet that has been thriving as of late is Facebook. Over 2015, Facebook's P/E ratio came in at 45.9, well over the S&P 500 average of 16.74. Facebook, due to its operations, makes majority of its revenues off of selling targeted advertisements on their website. Advertising revenue streams for Facebook in 2015 were reported as $17,079 million ($17,928 total revenue), showing how strong they rely on advertising to drive profits.25
With increasing numbers of people using the internet every day, Facebook can expect this number to continue to increase. Due to this, we feel the firm will benefit greatly from the continued success of the technology sector.26
World Index Tech Sector Alphabet Facebook
Industry Description
Internet Software & Services Industry
Alphabet Google falls under the Internet Software & Services sub-industry. The sector has increased in market capitalization by 17%, 16% and 14% respectively over the past three years. 15 Business lines most responsible for their success mainly fall under the internet advertising category. The primary segments offered by Alphabet include Web, Mobile, Business, Media, Geo, Specialized Search, Home & Office, Social, & Innovation. Product offerings from Alphabet consist more of intangibles such as their web service offerings, YouTube, & a wide array of advertising programs. In terms of physical products, Google offers their Chrome Cast media-streaming device and Nest smart-home devices.
World Index Returns Compared to Tech Sector, GOOGL, and FB
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Google Website Revenue Sources
AdWords, Google Chrome, Google toolbars, YouTube, Gmail, Google Finance, Google Maps, Google Play
Google Network Members’ Website Sources
AdSense, AdExchange, AdMob, DoubleClick
Google Other Revenues
Apps and Media content sales in Google Play, Chromecast, Cloud Service Fees, Nest branded hardware, Internet & TV services
Recent Developments & Industry Trends
Google Website Status Update
As the largest portion of Alphabet, Google websites contributed 67.4%, 68.6 % and 70.2% of their GAAP adjusted earnings for the previous three fiscal years.16 We feel the omni-presence of Google will continue to trend upward and preserve its ubiquitous level of awareness. One massive shift currently effecting this line of business is the movement towards more mobile advertising expenditures. Already slightly penetrating the mobile market with their Android operating system, they likely have a capable workforce and solid foundation to swiftly adjust to this new advertising focus.
Another trend in this particular industry sub-section is the growing number of those steering away from TV subscriptions, better known as ‘cord cutters’. Companies have started to prepare for the widespread cancellation of television services as the popularity of streaming media has become increasingly popular. Alphabet holds a good position in this culture change, as they would benefit greatly from an increase in internet based advertising demand. A good benchmarking measurement is the music streaming industry and the impact YouTube creates on it. Record
companies have been attempting to negotiate better terms with YouTube but have found they have minimal leverage. 17 Mentioned later in this report, Alphabet is in the process of launching a subscription based service, YouTube Red, which has the power to attract more traffic, and wider margins for recording deals.
Revenues deriving from programs and email databases are likely to account for the same percentage of profit. In a crowded market, Alphabet is positioned to remain a big player, but unlikely to capture more market share.
Google Network Members’ Websites
Recognized income from Google’s other websites has made up 24.6%, 22.1%, and 20.2% the past three years. 18 The decrease in growth can be explained by the inability to keep up with the growth experienced from Google websites. Revenues did manage a $500 million increase, but this numbers’ reliance on the overall growth of the global economy must be recognized. Slowing development in this category reflects on the deceleration experienced in the global economy for the most recent fiscal year. Income from the rest of the world (which excludes the United States & United Kingdom) make up 44% of all Googles consolidated revenues. 19 Coming off of a 23% increase in this category, they weakened to a 10% growth in 2015. Lackluster growth combined with the strong dollar caused this category to have a less than impressive year.
Google Other Revenues
Alphabet has much room to grow in this category and the restructuring of ‘Google’ into ‘Alphabet’ was a step in the right direction. Currently, there is not a wide variety of contributors to this revenue stream. However, the industry which this Alphabet’s other revenues falls under is not clear cut; the plan being to invest in new businesses, products, infrastructure improvements and acquisitions. 20 Nest products make up most of these figures, but we feel these products are before their adoption time and are not accurately represented well by their sales numbers. Forward looking, this division of Alphabet should not be categorized unambiguously. Our DCF model’s assumptions anticipate these figures to grow exponentially as they start to create new innovative and lucrative products. Beginning with the driverless car, Alphabet is arguably the front runner for this soon-to-
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Source: FactSet
market technological innovation which could deliver a large shock to the transportation industry. This market exalts a feast-or-famine product acceptance style which is perfectly in line with Alphabet’s ability to fund new projects.
Ticker Market Cap (b)
P/S Cash (b)
Cash as % of Rev
GOOGL $ 535 7.33 $ 16.55 22.5%
MSFT $ 446.6 3.92 $ 5.60 6.03%
YHOO $ 34.5 6.28 $ 2.66 53.46%
AAPL $ 595.9 2.76 $ 21.12 9.13%
FB $ 314.4 16.66 $ 4.9 27.33%
TWTR $ 1.2 6.91 $ .91 31.38%
BIDUexp $ 6.6 6.27 $ 1.38 13.17%
Markets & Competition
While Alphabet is characterized in the internet software and services industry, they operate under many different subsectors. Majority of revenues coming from advertising operations gives reason to classify Alphabet under the advertising industry, but their heavily technological weighted products give reason to organize them elsewhere. Competitors work under very similar principals, making it less clear who their largest contenders are.
Emergence into this market is not an easy task, yet those who have succeeded in earning relevance are capable of capturing more market share. That is one of the benefits of operating in such a large industry, Alphabet can better adjust due to necessary capital investment and time commitment. We feel our largest overall threat in this industry is Facebook (FB). Our reasoning for this is their versatility in the eye of the consumer. Originally considered merely a social networking platform, is now creating advanced algorithms and being used for measurable analytics in the presidential race. Facebook is another company that does not shy away from entering a market which it has no experience in- acquisition Oculus, a virtual reality headset creator. We believe Apple (AAPL) is a close second because of their product line offering in comparison to Alphabet. They sell more tangible items that don’t exactly align with Alphabet, thus capturing less market share from their most profitable operations.
Microsoft (MSFT) while it is a large company, they have focus more on polishing their current products, focusing on better operating margins. Twitter (TWTR) could have been considered a larger threat if it weren’t for its recent downgrade in the eyes of investors and their lack of confidence. Baidu (BIDU) is a popular search engine in Asia. They operate the closest to Google, however their size and niche target segment minimizes their threat level. Lastly, Yahoo (YHOO) is fighting a losing battle in the crowded search engine market. Consecutive poor decisions deem them irrelevant in the long term. Loyalty in the search engine industry allows Alphabet to maintain its lead while brushing off attempts of those that can’t keep up with innovation.
Catalysts for Growth/Change
Companies in the Internet Software & Services Industry are already some of the largest companies in the world when compared by market cap, however they all keep trying to grow through innovation and new ideas. We believe new projects and product lines will be catalysts for growth in these companies. Due to their massive amounts of cash, these companies can afford to invest in futuristic ideas with massive overhead costs and little revenues, but massive potential for another source of company revenue. 28
Aforementioned in this report, we foresee Alphabet leading the charge into the driverless car age. Visualizing future earnings potential for Alphabet, Facebook, and Apple requires out of the box thinking because they are in the business of innovation. For the internet services industry as whole, the issue of server bandwidth and physical computer space for said servers is a significant factor. All companies capable of heavy internet traffic need to be properly equipped to handle the flow, if upgrades these system efficiencies were captured, COGs could drastically decrease. Cost of revenues for Facebook increased 33% or $714 million to keep up with data infrastructure in 2015, accounting for 17% of overall revenues.29
Subsequently, traffic acquisition costs (TAC) for Google make up 37.6% of their revenues.30 Google Fiber is a project Alphabet has been pursuing which provides fiber optic internet service in large cities. This could be a precursor for reaching lower operating costs.
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Transitioning to new ways of accessing technology has a large impact on the industry. Moving towards more mobile devices is one direction of adjustment which came to strictly because of the way consumers chose to digest their information. Consumer behavior will have the largest effect on the internet industry due to its ever-changing structure. Using their extremely popular and free analytics and data analysis software, Alphabet has the tools to stay ahead of this curve and prevent missing out on opportunities. Google previously attempted to get into the wearable market with their ‘Google Glass’ design- their take on smart glasses. However, this product was unsuccessful and they have since completely stopped supporting it. Wearable technology has become more accepted and present an opportunity for future advertising methods and taking advantage of the internet of things.
Key Investment Positive & Negatives
Positives Electronic Device Demand
The largest distributor of internet enabled devices (phone, computer, tablet), Apple, continues to see increases in sales numbers year by year. Apple sold 28% more internet enabled devices in 2015 than in 2014. 31 This is an important metric for companies that deal in the internet software and services industry, showing the increasing number of users they can reach and monetize. Google, Twitter, and Facebook will all benefit by there being more internet traffic, theoretically allowing them to charge more for their advertising. This industry depends on users owning devices that enable them to connect to the internet, and with increasing sales in these devices brings more traffic to their websites.
Comfortably Levered in Industry
Alphabet operates at very comfortable debt-to-equity in accordance with such a cut throat, research and development intensive industry. If a recession were occur, Google would remain a sound investment without carrying too much market risk. Having this in combination with creating efficient operating margins makes this stock an attractive value opportunity.
Relentless Innovation
Innovation in the internet software and services industry is key for a company to be successful. Without
this quality, other companies can easily come up with a product or service that is more user friendly or better made than the previous, rendering a product obsolete with little warning. This competition between the three main companies here is a positive for the investor because it shows the growth in the industry as a whole. There are big players in this field, such as Alphabet and Facebook, but new companies continue to try rise up in this industry, which forces other companies to push the envelope. A quality benchmark measurement of a firm’s innovation can be seen through R&D. In 2014, Facebook purchased WhatsApp for $17.2 billion. This move was done to try and expand services into different parts of the world, as the app had users from many different countries, including third world nations. This move enables them to reach different markets and users from all around the world, and gave them an advantage over other platforms. 32
Negatives All Eyes on Alphabet
This is more of a caveat to the positive investment keys of large competition and constant innovation. Both of those factors, while positive, lead to a large threat of substitution. Google has recently been getting themselves in hot water due to the neglect to abide by foreign laws. The EU in particular, has filed multiple law suits toward them for disregarding their ‘failure to be forgotten law’. 33 This is cause for some concern due to their track record- they have already been banned from China for similar reasons. In a more recent case with Google, they have been scrutinized and subpoenaed for scanning in over 20 million books into their own database for searching purposes.34 In this
Source: Alphabet 10-K, Yahoo 10-K, Facebook 10-K
2015
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Google Other
Revenues, $7,151
Other Bets, $448
Google Websites, $52,357
Network Members' Websites, $15,033
Advertising Revenues, $67,390
REVENUE STREAMSindustry where bold decisions make or break companies, being the first to revolutionize will come with difficulties which can include unexpected financial hemorrhaging.
Cyber Threats
Cyber security is a severe issue that can arise in the internet software and services industry. The increasing amount of users online, makes much information susceptible, putting it at risk for being stolen or used illegally- discrediting the company’s reputation. To Alphabet’s benefit, Facebook is also at risk getting into trouble with cyber security. Unlike alphabet, Facebook takes users information into account when supplying adds to users. Advertisements on their website drive 92% of their revenues, a massive portion of the firms overall revenues. If this information that they have stored on their users gets out, users could feel unsafe with having their information on there, and leave Facebook, which would then subsequently lower the going rate for advertisement deals.35
Company Specific Analysis
Company Overview
Alphabet Inc. (GOOGL) is the contemporary goliath of innovation and advertising powerhouse of the Internet Software & Services industry. It was founded in 1998, headquartered in Mountain View, California. Originally providing just a search engine, Alphabet now holds 8 distinct subsidiaries specializing from anti-aging research labs to self-driving cars. As a company, they focus mainly on cultivating creativity and solving large problems. Implementing a “what if” attitude has allowed Alphabet to become the second largest publicly traded company in the world with an attractive future.
Products & Revenue Generation
Previously Google, the company announced in August 2015 the creation of their new holding company, Alphabet – with the intention to broaden its product/service offerings. Posting an 89.8% revenue from advertising shows the company operates with great margins and minimal inventory requirements.
Google Websites – An account on the financials which includes AdWords on their personal website. Also includes other first tier products such as YouTube, Gmail, Maps and Finance. Paid per clicks advertisements in 2015 increased 4% to reach 33%, mainly attributed to the increase in engagement ads. Adoption of this new style ad may increase the popularity and effectiveness of these tools.36 We anticipate 22% growth for this division for the next 2 years from success capture of mobile market share and Yahoo’s losses. After we expect it to slow by 4% each year until reaching economic growth.
Google Network Members’ Websites – Revenues that derive from AdSense, AdExchange and other websites that use Googles advertising services. These streams rely on the health and growth of other businesses. We can expect these revenues to be positively correlated with the growth of the online shopping, and consumer confidence. This division is also very reflective on the economic growth. However, due to the cord cutting phenomena we feel 2016 will deliver an 8% grow rate relative to previous year performance, then decelerate to 6 - 7 % before reaching economic growth.
Google Other Revenues– Inflows from operations other than advertising include the sale of content via the Google Play store, licensing, and the sale of hardware – Chromecast and Nest. We believe Chromecast is nearing market saturation. As year-over-year sales halved in 2015, lowering to 18.2% from previously reaching 36.4%. Revenues from Nest products have increased 121 million from 327 to 448 in 2015. The division being acquired in early 2014, these numbers don’t give much insight for future expectations.37 We expect rapid growth in this division
Source: Google 10-K 2015
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Source: Yahoo Finance, ThomsonONE
Source: FactSet
at 35% due to the perceived success of new ventures near completion.
Analysis of Recent Filings (Earnings & Guidance)
Alphabet has beaten their expected EPS as well as revenues for 3 of the 4 quarters in 2015. The Google segment of Alphabet doesn’t commonly release guidance around earnings time, however they have continued to grow exponentially alongside lackluster analyst speculations. Upon receiving the successful Q4 2015 earnings report, few important key metrics stand out. Google’s operating margins have consistently reached high levels above 25% - currently at 26.2%.38 In comparison to other competition in the Internet Search industry, Alphabet’s numbers have shown great profitability from operations while expecting long term increases. Posting these types of operating margins whilst simultaneously working towards monetizing new ventures reflects their conscientiousness to expand at a healthy rate.
Ticker OP
Margin OPM YoY Change
D/E
GOOGL 26.20% 3.16% 4.34%
MSFT 29.65% ‐7.43% 44.07%
YHOO ‐2.72% ‐157.26% 4.25%
AAPL 33.68% .61% 54.01%
FB 45.57% ‐4.19 ‐40.98%
BIDUexp 15.77% ‐24.94% 48.44%
Comparison between Alphabet’s profitable competitors in FY2015 allows investors to find solace when trying to justify the company long term plans. Relying heavily on R&D, Alphabet will need to
continually find sources of funding. Maintaining an extremely low debt responsibility they should have little obstacles funding future endeavors, regardless of the economies’ status.
Competition & Differentiation
The Google segment faces the most search engine opposition, however they currently pose little threat. Globally – as of January 2016, Google holds 65.44% of the market share. Remaining usage falls primarily into the hands of Bing (15.82%), Baidu (8.3%), and Yahoo (8.28%). Moving ahead, we anticipate multiple opportunities for other companies to cannibalize market share.
Bing – Microsoft’s Bing poses the biggest potential threat to Google in the search engine industry. In 2012, they launched the campaign “Bing it on” as an attempt to demonstrate they were the better search engine via blind comparison. Advertising for search engine use was uncommon up to this point; the campaign increased visibility. Browser use is a significant contributor when determining search engine use. People using Windows Operating Systems are more likely to use Bing, as it automatically is chosen as the browser. 39
Facebook – Previously mentioned in this report, we feel Facebook is the largest overall competitor which is most capable of capturing pertinent marketshare. We believe Alphabet is an unorthodox company, leaving its biggest threat to be those that are more unconventional. In a study of 5,000, 60% of Millennials said that keeping up with news is a daily online activity. Directly lagging behind at 59%, is keeping up with what friends are doing.40 Facebook updates their product weekly, moving closer to
6.936.74
7.21
8.10
6.88 6.99
7.35
8.67
6
6.5
7
7.5
8
8.5
9
Q1 Q2 Q3 Q4
EPS Actual vs Estimates (FY 2015)
EPS Estimates EPS Actual
65.44%15.82%
8.30%
8.28%
0.24%
0.15%Total Global Market Share(US searches per yr)
GoogleBingBaiduYahooAskAOL
Source: NetMarketShare
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capturing more of the search engine market. Millennials are the largest populated age cohort, a shift towards Facebook’s search engine could be detrimental to Alphabet’s revenues. Baidu – After more Google products were banned in China in late 2014, it proposed a great entry point for another company to step in. With the search engine already prohibited in 2009, Baidu was still unable to capitalize and create significant growth in revenue for the subsequent quarter. CEO Robin Li believes Google wouldn’t pose a major threat, and claims mobile will eventually render their core business obsolete.41
Inability to adapt to the obvious market demands signals contempt in their current state. Before being banned, Google held around 33% of the market while Baidu held a little over 60% Google has been fighting to reestablish itself in China, if successful, they have a much higher chance of capturing the mobile market. Apple – While not considering Apple as our most viable competition, they still have the potential to leave a big impact. As the clear front runner for phone sales, they have a large following which has a strong influence on Alphabet’s Android sales. iPhone products have many ‘make or break’ qualities that consumers feel are a nowhere near being replicated by competition. Damaging phone sales is a serious issue, however if they were able to proprietarily hold mobile advertising market share unique to iPhones, Alphabet would suffer massive loss. This may not be an issue at hand but with Apple cutting iPhone output by 10%, they may aggressively search for new sources of revenues such as this. 42 Yahoo – Out of Google’s largest competitors, Yahoo is the least likely candidate to capture any more market share. Losing touch with their demographic and failing to improve has led them to their current position of non-profitability. CEO Marissa Mayer has announced a restructuring strategy that appears more as a last stand to turn the company around. Trading at a considerable acquisition price, we believe they are preparing to change hands and should continue to lose market share.
Catalysts for Growth/Change
Advertising revenue is the clear victor when determining branches of profitability within Alphabet. Carrying expectations for future growth in Network Members Websites will also bring an increase in Traffic Acquisition Costs (TAC). Revenues increased $494 million in 2015 to reach $15,033 million. TAC costs to Google Network Members increased $378 million to reach $10,242. Cost of revenues as related to network members increased from 67.85% to 68.13% in 2015. 43 In order for Alphabet to make efficient use of their future growth in this category, they will need to focus more on ways to reduce operating costs. If a method of higher profit retention is discovered, it will present a considerable opportunity for future performance.
Key Investment Positives & Negatives Positives Diversified Entity Structure Alphabet has deeply rooted itself into the advertising market but has also branched itself into a widely diversified product variety- bestowing a stop-loss benefit for revenue forfeiture. Pushing new revolutionary products first, they have much more flexibility with margin spreads, avoiding status quo pricing models. Alphabet exercised great timing by restructuring their company at the time they did. Having high cash profits gives them lots of free reign to finance new ventures, making them less risky for investment.
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Attracting Talent
Google’s work environment is considered utopic in the eyes of millennial workers entering the work force. Exposure as a company who takes pride in their employees as well as compensating them extraordinarily well with benefits goes a long way with younger talent. These Google specific benefits allow them to recruit top talent without having spent too much time recruiting. Yearly events at the HackMIT hosted by Massachusetts Institute of Technology is an event where Google discovers top computer hacking at a low cost while simultaneously improving their security.44
Negatives Acquisition Turmoil
Taking over companies for the foreseen potential is fair reasoning to acquire a company up to a point. Alphabet has previously obtained companies with great intentions but have found themselves somewhat in over their heads. Boston Dynamics- a robotics company Google took over in 2013- seemed like a radical decision at first. However, the once CEO of that had passed, they lost the ingenuity and hit a brick wall with progress. Boston Dynamics has since been put up for sale from Google- with no potential buyers.45 Another example of this comes from the management brought over from Nest. Productivity had experienced a drastic slowdown as the work force of the subsidiary felt overworked. 46 Since then, Nest has had a shakeup with executive and lower level positions. These are signals that Alphabet needs to qualify their impending acquisitions with more thorough examination.
Valuation Analysis
Key Assumptions
Revenue Decomposition
Alphabet Inc. obtains roughly 90% of its current total revenue from advertising operations. This business segment is vital for Alphabet to focus on. Therefore, we predict advertising revenues to increase at a decreasing rate until final growth year 2020, where it converges at 4.5%.
In 2012 and 2013 Alphabet earned close to $8 billion in revenue from Motorola Mobility. This acquisition showed the ability to diversify revenue sources outside the realm of advertising. The idea of Alphabet expanding into new products is consistent with our belief for their future as a company. We expect Alphabet to be a leader in cutting-edge technology over the next 5 years, and can expect revenue sources labeled “other” to be broken down into specific categories. Our forecasted growth rates for other revenues increases by 35% in 2016 and converges down to 4.5% in 2020.
Cost of Goods Sold/R&D
For the past 10 years Alphabet’s COGS and R&D have increased every year. These numbers support our belief that Alphabet is a leader in innovation and product development. In our 5 year forecast we believe Alphabet will continue to expand into new products which will cause COGS to increase by more than 30% and R&D to rise by approximately 18%. Alphabets historical R&D numbers and company vision align with our future predictions.
Weighted Average Cost of Capital
Alphabet’s Weighted Average cost of Capital (WACC) was calculated at 6.92%. To obtain this number we first calculated the Cost of Equity using the Capital Asset Pricing Model approach. To complete this model we used Bloomberg to find the raw Beta of Alphabet and the risk free rate. We then calculated the Market Risk Premium to get a final cost of equity value of 7.02%.
We then continued on to compute the Cost of Debt by multiplying the Pre-Tax Cost of debt by the Marginal Tax Rate to yield an after-tax cost of debt at 2.32%. Capital Structure Weights were than applied to calculate the market value of equity by multiplying current shares outstanding by the current market price to equal $521,967. The book value of debt was then calculated by adding long-term debt, short-term debt, and present value of operating leases equaling $10,699. The WACC of 6.92% was then applied to the DCF and EP approach, presented next.
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Discounted Cash Flow and Economic Profit
Our DCF and EP model both yielded an intrinsic value of $843.94 which was then adjusted to $861.32 for the elapsed fraction of the year. This model predicts a 14.5% increase from the current value of $751.72. The market is possibly underestimating Alphabet’s future potential to generate revenue from other sources. So, based on this approach we believe that the stock is currently undervalued.
Dividend Discount Model
Before performing any valuation models we estimated Alphabet’s stock price to increase by 15%-20% over the upcoming year. The Dividend Discount model yielded an intrinsic stock price far below the current trading value at $495. Alphabet does not currently pay a dividend so we used industry averages to complete this model. Since Alphabet is a high-growth company and is not similar to many companies in their industry, we believe that this model should be discredited due to its lack of accuracy.
Relative Valuation
Comparing Alphabet to other similar companies is a tough task. Alphabet is in a stage of high-growth with an incomprehensible level of future potential. However, we were able to find 4 companies that had similarities suitable for this model. After removing several company outliers we chose Apple, Twitter, Baidu, and Facebook. We calculated each companies’ EPS and P/E ratio for 2016 and 2017 to finally obtain the PEG ratio in each of those years. We then compared the previous companies to Alphabets similar ratios, obtaining the Relative P/E for 2016 at $591.81 and the PEG ratio for 2016 at $219.60. These values are considerably low and should not be acknowledged when issuing a rating. As stated earlier, Alphabet is a very unique company and relying on valuations that only compare ratios to other companies is not adequate.
Sensitivity Analyses PP&E Growth Rate to Other SG&A Expense: These two variables were chosen to reflect potential growth in Google’s long-term assets and other expenses not related to production of goods. SG&A expense is one of the biggest operating expenses Alphabet currently shows on its income statement. PP&E has a very large impact on Total assets and testing these two important metrics yielded us a intrinsic value range between $1,047 and $639. COGS Growth Rate to Marginal Tax Rate: Cost of Goods Sold (COGS) is another important operating expense that must be monitored. An increase in COGS can represent better company performance or a need to look at pricing of production. Marginal Tax Rate is a simple yet important company specific factor but it is also affected by government policies. These comparisons yielded us a stock price between $1,069 and $619. Economic Growth Rate to Network Member Ad Growth Rate: Advertising revenue is currently a majority of total revenue for Alphabet. Tracking a specific sector of that revenue is important to watch how Alphabet maintains its dominance. The economic growth rate is a great metric to track how Alphabet advertising revenue correlates to the overall economy. These two variables were positively correlated and this sensitivity analysis yielded a range between $934 and $751. R&D Growth Rate to WACC: Research and Development growth rate is a significant variable surrounding Alphabet. We predict that this number will increase over the next 3-4 years and it is an interesting comparison to the weighted average cost of capital. As predicted a higher share price is created when R&D growth rate increases and the WACC decreases. The range for this analysis is $1,010 to $740.
Important Disclaimer
This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report
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also provides potential employers and other interested parties an example of the students’ skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report. 1 Bureau of Labor Statistics 2 Bureau of Labor Statistics
3 Bureau of Economic Analysis 4 Federal Reserve ( Chart & Data used for predictions) 5 Wall Street Journal <http://www.nasdaq.com/article/us-sets-tougher-rules-on-tax-deals-20160405-00054 >
6 The Conference Board, Consumer Research Center 7 Surveys of Consumers University of Michigan < http://www.sca.isr.umich.edu/ >
8 Bureau of Labor Statistics < http://www.bls.gov/web/empsit/ceshighlights.pdf > 9BloombergNews http://www.bloomberg.com/news/articles/2016-01-29/fourth-quarter-growth-sentiment-cool-u-s-economic-takeaways
10 Bureau of Labor Statistics U.S. Department of Labor http://www.bls.gov/news.release/pdf/empsit.pdf 11Investopedia http://www.investopedia.com/terms/e/exchangerate.asp 12 Fisher Investments on Technology (pg. 56-67)
http://www.investopedia.com/terms/t/trade-weighteddollar.asp 15 NetAdvantage Standards & Poors: < Sub Industry review IT Software & Services > 16 Alphabet 10-K, 2015 17 Wall Street Journal < Streaming Gives Music Industry a Lift—Global Revenue from recorded music grew 3.2% >
27 FactSet Data 28 The Guardian <https://www.theguardian.com/technology/2016/feb/05/x-projects-alphabet-moonshot-ventures-change-world-robots> 29 Facebook 10-K, 2015 30 Alphabet 10-K, 2015 31 Apple 10-K, 2015 32 Tech Radar < Facebook Buying Whatsapp- it’s about the Developing World> 33 Bloomberg: Technology <Google and EU Wrangle Over ‘Right To Be Forgotten’> 34 Wall Street Journal <Supreme Court Rejects Challenge to Google book-scanning Project> 35 Facebook 10-K, 2015 36 Alphabet 10-K, 2015 37 Alphabet 10-K, 2015 38 FactSet 39 Forbes <http://www.forbes.com/sites/jaysondemers/2015/02/04/is-bing-finally-catching-up-to-google/3/#5ed26ec86e72> 40 AmericanPress Institute: Media Insight Project 41 Wall Street Journal <http://blogs.wsj.com/chinarealtime/2016/02/15/baidus-robin-li-on-search-giants-success-it-isnt-because-google-left-china/> 42 Credit Suisse Analyst Report 43 Alphabet 10-K, 2015 44 Massachusetts Institute of Technology: HackMIT 45 Bloomberg: Technology < Google Seeks Buyer for BD > 46 Business Insider < What is going on at Nest>
Other SG&A Expense843.94$ 17.00% 18.00% 19.00% 20.00% 21.00% 22.00% 23.00%
Class A & B common stock & additional paid-in capital 25,922 28,767 32,982 34,466 38,612 43,258 48,461 54,291 Accumulated other comprehensive income 125 27 (1,874) (1,874) (1,874) (1,874) (1,874) (1,874) Retained Earnings 61,262 75,066 89,223 105,731 125,631 149,058 174,133 197,191 Total Stockholders Equity 87,309 103,860 120,331 138,323 162,369 190,442 220,720 249,608 Total Liabilities and stockholders equity 110,920 129,187 147,461 166,253 195,191 228,374 262,696 293,272
Alphabet, Inc.Cash Flow Statement
Fiscal Years Ending Dec. 31 2013 2014 2015Operating Activities Net Income 12,920 14,444 16,348 Adjustments:
Depreciation & amoritization of property & equipment 2,781 3,523 4,132
Amoritization of intangibles & other assets 1,158 1,456 931
Stock-based compensation 3,343 4,279 5,203
Excess tax benefits from stock-based award activity (481) (648) (548)
Deferred Income taxes (437) (104) (179)
Impairment of equity investments - - -
Other, net (594) (938) 546
Changes in assets and liabilitites:
Accounts Receivable (1,307) (1,641) (2,094)
Income taxes, net 401 283 (179)
Prepaid Revenue share, expenses & other assets (930) 459 (318)
Accounts Payable 605 436 203
Accrued expenses & other liabilities 713 757 1,597
Accrued revenue share 254 245 339
Deferred revenue 233 (175) 43
Net cash flows from operating activities 18,659 22,376 26,024
Investing ActivitiesPurchases of property & equipment (7,358) (10,959) (9,915)
Purchases of marketable securities (45,444) (56,310) (74,368)
Maturities and sales of marketable securities 38,314 51,315 62,905
Investments in non-marketable equity securities (569) (1,227) (2,172)
Cash Collateral received (returned) from securities lending (299) 1,403 (350)
Investments in reverse repurchase agreements 600 (775) 425
Business acquisitions (1,448) (4,888) (236)
Other 2,525 386 -
Net cash flows from investing activities (13,679) (21,055) (23,711)
Financing ActivitiesNet proceeds (payments) from stock-based award activities (781) (2,069) (2,375)
Excess tax benefits from stock-based award activity 481 648 548
Repurchase of common stock in connection with acquisitions - - -
Proceeds from issuance of debt, net 10,768 11,625 13,705
Repayment of Debt (11,325) (11,643) (13,728)
Net proceeds from a public offering - - -
Other (1,827)
Net cash flows from financing activities (857) (1,439) (3,677) Effect of exchange rate changes on cash and cash equivalents (3) (433) (434)
Net increase (decrease) in cash & cash equivalents 4,120 (551) (1,798) Cash & cash equivalents at the beginning of year 14,778 18,898 18,347 Cash & cash equivalents at the end of the year 18,898 18,347 16,549
Alphabet, Inc.Forecasted Cash Flow Statement
Fiscal Years Ending Dec. 31 2016E 2017E 2018E 2019E CV 2020EOperating Activities Net Income 16,508 19,900 23,427 25,074 23,058 Adjustments to reconcile net income to cash from operating activities:
Depreciation and Amoritization 5,508 6,598 7,720 8,608 8,996
Accounts Receivable, net (231) (236) (240) (245) (250)
Inventories - - - - - Deferred Income Taxes, net (198) (39) (40) (32) (14)
Other Current Assets (1,632) (1,410) (2,717) (1,295) (565)
Prepaid Revenue share, expenses and other assets, non-current (882) (804) (828) (655) (286)
Deferred Income Taxes net, non-current (171) (84) (86) (68) (30)
Shares Outstanding (beginning of the year) 687 698 708 719 730 741 751 762 773 784Plus: Shares Issued Through ESOP 11 11 11 11 11 11 11 11 11 11Less: Shares Repurchased in Treasury - - - - - - - - - - Shares Outstanding (end of the year) 698 709 719 730 741 751 762 773 784 795
VALUATION OF OPTIONS GRANTED IN ESOP
Ticker Symbol GOOGLCurrent Stock Price $759.39Risk Free Rate 0.00%Current Dividend Yield 0.00%Annualized St. Dev. of Stock Returns 38.80%
Average Average B-S ValueRange of Number Exercise Remaining Option of OptionsOutstanding Options of Shares Price Life (yrs) Price GrantedESOs 4.9 221.31 3.70 544.05$ 2,665$ RSUs 25.7 531.74 2.70 298.74$ 7,690$ Total 31 376.53$ 0.21 382.87$ 10,355$