David Rolfe Makes Interesting Case for Alphabet

A review of the guru's original take on Google's parent company Continue reading... Read More...

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="I try to read Wedgewood Partners' quarterly letters whenever I can because David Rolfe (Trades, Portfolio) often goes into interesting and detailed discussions of portfolio companies. Without question, the portfolio managers are extremely knowledgeable about these names.” data-reactid=”11″>I try to read Wedgewood Partners’ quarterly letters whenever I can because David Rolfe (Trades, Portfolio) often goes into interesting and detailed discussions of portfolio companies. Without question, the portfolio managers are extremely knowledgeable about these names.

One of those discussions in the latest letter that I really liked was the break-down of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). I’ve owned Alphabet on and off over the years and currently follow it with interest from the sidelines. Rolfe’s discussion stood out to me because he raised original points on a name where often the same talking points come up time and time again:

“In addition to continued revenue growth, we think Alphabet has ample room to improve both margins and capital allocation over the next several years and drive excess returns. Over the years, we have seen Google change its search and advertising algorithms on a regular basis, and sometimes those changes can have a disproportionate impact on quarterly revenues, but they are usually temporary. After dropping to mid-teens growth in the first quarter of the year (from the mid-20’s during 2018), shares sold off and provided an attractive opportunity to add to positions, given Alphabet’s history of tweaking its Google model and the associated short-term effects. Since then, advertising revenue growth has accelerated and is back to nearly 20% growth.”

Rolfe expects Alphabet to grow revenue at around 20%, improve margins and do better on capital allocation. If that happens, which I believe has odds of two out of three, it would result in earnings or free cash flow going up exponentially. He also makes an interesting point about Google (the search part of the business) that rolls out algorithm updates from time-to-time with funny names like Panda. These can really disrupt online businesses and Google’s ad revenue for a while. Yet, they are important because Google must continue to optimize the user experience. I believe there is a reason there is not really a challenger in the search market, and that’s because Google seems to optimize the time users are in contact with them over any current year revenue. Here is another exerpt from Wedgewood’s fourth-quarter shareholder letter:

“Importantly, Google’s owned and operated properties continue to exhibit healthy growth, which are higher margin revenues relative to its largely pass-through Network Member revenues.”

I’m not sure if I agree here entirely. Yes, it’s great to have owned and operated properties with healthy growth that come at higher margins versus pass-through network members. However, generating revenues from network member revenue is the ultimate scalable platform. It allows Google to essentially hold a royalty on the revenue growth of millions of websites and businesses across the world. YouTube is an exceptional property because it also thrives on user-generated content, but the last thing I’d want to see is Google make investments in media like Apple (AAPL) is doing.

“A key driver of Google property growth continues to be mobile search, as well as increased monetization of YouTube. IDC estimates that around 8 in 10 smartphones shipped globally are Android-based, which typically come preinstalled with Google search and/or Google’s mobile browser. As for Apple iOS devices (iPhones and iPads), we estimate Google’s traffic acquisition costs (TAC) for Apple device traffic has plateaued over the past year or so and expect the growth of this expense to be more in line with iOS device growth (we estimate mid-single digits) longer term and should represent an attractive opportunity for margin expansion.”

This looks unlikely to change in the near term. If there’s one flaw of Rolfe’s discussion, however, is that it doesn’t go into the voice-commanded interfaces that are starting to rise. Everyone who’s familiar with Amazon’s (NASDAQ:AMZN) Alexa or Google Assistant knows how powerful this interface is. Yet, it isn’t as clear-cut how voice can be monetized.

“As for YouTube, Alphabet’s management considers it to be “TAC-free,” so continued strong growth in this Google property should help bolster ex-TAC revenue longer term, as well. Earlier this year, Alphabet gave a bit of incremental disclosure about the size and growth of its GCP service, which provides cloud infrastructure as a service to developers and IT departments. We estimate that this platform is likely outgrowing industry leaders AWS and Microsoft Azure, albeit from a smaller revenue base. While the Company does not disclose its cloud profitability, we expect GCP to drive incremental profit-dollar growth as this business gets larger and utilization rates increase.”

If the platform could outgrow Amazon and Microsoft’s (NASDAQ:MSFT) platform businesses, that would be terrific news. Both these companies are getting a lot of credit for these platforms, but Alphabet, not so much. Investors primarily focus on its cash-gushing ad business.

“Alphabet also has a couple of return-enhancing capital allocation options at its disposal. First, Alphabet is sitting on a mountain of cash, around $120 billion, and should generate close to $25 billion in free cash flow during 2019. We expect the Company to double its free cash flow over the next couple years with just a modicum of capital expenditure discipline.”

Alphabet is nearly a trillion in market cap, but $120 billion still represents a sizeable part of that. If it could start generating $50 billion in free cash flow, it would trade at reasonable value of 20 times free cash flow (given it is such a fast-growing business, with a great balance sheet and embedded options).

“Second, if Alphabet’s historical trend of few large acquisitions continues, we would expect the Company to buy back stock at what would be a very attractive forward free cash flow multiple, especially relative to drop-dead (i.e. negative) rates on debt issuance around the globe.”

The company is currently in the process of acquiring Fitbit (NYSE:FIT), but that’s only about $4 billion. Its been a long time since Alphabet really laid out sizeable sums to acquire anything.

“Last, we think Alphabet’s “Other Bets,” which represents a gaggle of noncore, under-disclosed, money-torching projects that have very little bearing on Google’s business, could easily be wound down. We estimate this could save shareholders between $3 billion and $5 billion per year and could be used to reduce the Company’s share count or supplement M&A”

Other bets like Waymo and Verily could theoretically be shut down. Some of that has been going on over the years, but Alphabet has always spent princely sums on esoteric bets. With the acquisition of Fitbit, I don’t see the shutdown of Verily anytime soon, and Waymo is a leader in autonomous driving, which is potentially incredibly valuable (even though it is a very expensive investment). By the time Chief Financial Officer Porat arrived, we had already seen an improvement in capital allocation. Perhaps the recent promotion of Pichai to CEO of Alphabet will result in further improvements, but I’m definitely not as sure as Rolfe.

The stock is also very attractive compared to a set of peers, as per GuruFocus data. Alphabet ranks great on profitability as well as financial strength on a relative basis. I like it much better than most similarly structured companies.