Alphabet: Exceptional Q4 Supports Low-Teens Annualized Return Investment Case (NASDAQ:GOOG) (2024)

Introduction

Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) released Q4 2020 results overnight (February 2); Class C shares rose 7.2% in post-market trading to $1,927.51.

We initiated our coverage of Alphabet with a Buy rating last week, with a 2024 exit price of $2,818 and an expected 61% total return (13% annualized).

Q4 results were ahead of our expectations and support our long-term investment case on the stock, as we will explain below.

Buy Case Recap

Our investment case on Alphabet sees it growing EPS sustainably at a CAGR of low-teens, based on revenue growing low-teens, with:

• Mid-single-digit growth in Search & Other, with the advertising sector growing at GDP or faster, and Google gaining share thanks to its competitive advantages, especially its network effect
• Strong double-digit growth in YouTube Ads, a relatively new product growing at 30%+ a year in recent years
• Strong double-digit growth in Google Cloud, which has a differentiated strategy and can leverage Alphabet’s unique advantages

We expect EBIT to grow slightly slower than revenues, with operational leverage from relatively fixed OpEx like R&D being offset by Gross Margin shrinkage (from both mix shift and higher server and datacenter costs).

We expect share buybacks to reduce the share count by approx. 1.5% each year, and for this to help drive giving EPS growth to low-teens overall.

We expect the P/E multiple to be broadly stable at the then 35x figure, due to Alphabet's strong long-term growth potential and “lower for longer” interest rates. We also believe P/E does not include the substantial value in Other Bets, which are loss-making in aggregate and so not captured in earnings-based valuation methodologies.

Q4 2020 is the first set of results after our initiation, and sees Alphabet performing either in line or better than the above.

Segment Results

Alphabet's CFO described Q4 2020 an "exceptional fourth quarter performance after an unprecedented year”. Google ad revenues continued to rebound during the quarter to $46.2bn, up 24.5% from Q3 and 21.8% year-on-year:

Management saw "broad-based increases in advertiser spending" during Q4. Retail was the largest contributor to year-on-year growth; Technology, Media & Entertainment and Consumer Packaged Goods were also strong contributors. The high ad spend was helped by more consumers moving online and advertisers responding by reactivating spend that was paused earlier in 2020.

Facebook (FB)'s Q4 results, which we wrote about last week, showed the rebound in ad spend in more detail, with ad impressions growth again strong in the quarter and average price per ad rising for the first time in 2020:

Within Google's ad revenues, the more traditional lines in Search & Other and Network Members' Properties grew 17.4% and 22.9% year-on-year respectively. The newer YouTube Ad line grew 46.0%, driven by both brand advertising and newer direct response ads:

For full-year 2020, despite COVID-19 and the relative maturity of Search, Search & Other revenues were up 6.1% year-on-year. With YouTube Ad revenues up a strong 30.5%, total Google Advertising revenues were up 9.0%.

Outside advertising, in Q4 2020, Google Other (which includes YouTube subscription revenues) revenues were up 26.8% and Google Cloud revenues were up 46.6%, similar growth rates to their full-year performance, as these businesses continue their strong momentum.

Total Alphabet EBIT grew 68.9% year-on-year in Q4, thanks to operational leverage (with Google Services' EBIT margin rising 500 bps). Total Alphabet EBIT was reported as growing 20.4% for the full-year, but this was helped by lapping a prior-year European Commission fine (more below).

Google Cloud EBIT was disclosed for the first time, with figures going back to 2018 (as shown in table below). It is currently running at a loss of $1.2bn per quarter, stable sequentially after seasonably higher Q1 2020 ($1.7bn):

Google Cloud revenues have more than doubled since 2018 and Alphabet's group backlog, which is “nearly all attributable to Cloud”, tripled from 2019 to 2020, signalling the substantial near-term momentum in this business.

Group P&L

In Q4 2020, group revenue grew 23.5% and EBIT grew 68.9% year-on-year, as Cost of Revenue grew roughly in line with revenues while OpEx was lower:

OpEx was lower year-on-year in Q4, due to the lapping of high share-based compensation costs (especially for Other Bets) in Q4 2019 and cost control in response to COVID-19.

For full-year 2020, excluding the prior year European Commission fine, EBIT grew 14.7% on a revenue growth of 12.8%, showing the benefit of operational leverage. Net Income grew at a different rate due to volatile Other Income and a higher tax rate, and was up 17.3% (including lapping the prior-year fine). EPS was up 19.2% after buybacks helped reduce the share count by 1.7%.

2021 Comments

On revenues, management did not provide guidance. They did share some remarks on how year-on-year growth rates would vary during the year, as COVID-19 meant easier comparables in H1 and more difficult ones in H2.

On costs, management expects the “pace of investment to increase”, and costs “will ramp up over the course of the year”, including a reacceleration in hiring. Similar to Facebook, Alphabet is making an accounting change in lengthening the useful life of servers and network equipment, thereby spreading depreciation charges over a longer period. In 2021, this will mean a $2.1bn benefit, adding 5% to EBIT growth.

On CapEx, management expects a “sizeable increase in CapEx” after the slower pace in 2020, with servers being the largest driver of technical infrastructure.

Google Cloud is also expected to show the similar seasonality in EBIT, with higher losses in Q1, as in 2020.

Cashflows & Valuation

At $1,927.51, on 2020 financials, Alphabet shares are trading at a P/E of 29.9x (excluding $112bn of net cash, equivalent to 9% of the current market capitalization), and a Free Cash Flow ("FCF") Yield of 2.4%:

As mentioned at our initiation, we believe these multiples overstate how expensive the shares are, as the Other Bets generate negative reported earnings and cashflows, and yet are likely to be worth substantial amounts. “Non-marketable securities”, which include Other Bets, carried a $20.7bn value on Alphabet's balance sheet at Q4, or 1.6% of its current market capitalization.

Illustrative Return Forecasts

Alphabet's 2020 Net Income of $40.3bn was 13% higher than our forecast of $35.6bn. Given this higher base, we have reduced our 2021 Net Income growth rate from 10% to 3%, but kept other assumptions unchanged:

• From 2022, Net Income grows at 10% each year
• Share count falls by 1.5% a year, giving an 11.7% EPS growth from 2022
• P/E at 35x at 2024 year-end (no change), a re-rating up from current 30x
• No dividends

These give a 2024 EPS of $85.36, 6% higher than the previous $80.52.

At current price of $1,927.51, the above gives an exit price of $3,160, which implies a total return of 79% (13.4% annualized) in just under 4 years:

Conclusion

Alphabet reported "exceptional" Q4 2020 results overnight, sending shares up 7.2% post-market and supporting our long-term Buy case.

Google ad revenues were up 24.5% from Q3 and 21.8% year-on-year, thanks to a broad-based rebound in ad spend, especially among retailers.

For full-year 2020, despite COVID-19, revenues were up 6.1% in Search & Other and 30.5% in YouTube Ads; Google Cloud grew 46.4%.

Helped by cost control during the outbreak, comparable EBIT grew 14.7% year-on-year in 2020; lapping a prior-year fine, EPS grew 19.2%.

At $1,927.51, shares can have an exit price of $3,160 and a total return of 79% (13.4% annualized) in 4 years, by 2024 year-end.

We reiterate our Buy rating on Alphabet.

Note: A track record of my past recommendations can be found here.

Librarian Capital