Alphabet Inc. (NASDAQ:GOOG, NASDAQ: GOOGL) released its latest quarterly results on Tuesday afternoon. The company missed estimates on both lines, and earnings actually fell year over year. Nevertheless, I believe that the company is a bargain at current prices, and overall recent quarterly results have reinforced my belief that GOOG is currently trading below fair value.
Main results Missed estimates
The following screenshot captures headlines from Alphabet’s latest quarterly publication:
Alphabet missed both the analysts’ consensus estimate for its revenue as well as the consensus estimate for its earnings per share. That’s understandably not great, especially since earnings per share also fell year over year from $1.36 to $1.21. So the headlines look pretty bad, but when you take a closer look, things are much more nuanced.
A deeper look at the neighborhood’s good and bad
Starting at the top of the income statement, let’s examine the factors that caused Alphabet’s earnings per share to decline from the prior year period.
Revenue increased 13%, driven primarily by the strength of the company’s core Google search business. Google Search is the company’s largest and most established business unit, yet it has seen the best growth. To me, this indicates that Alphabet has major advantages over its peers in the online advertising space. Others, like Twitter (TWTR) and Snap (SNAP), have disappointed in this regard with their recent earnings releases, but Alphabet’s business remains strong.
YouTube saw some revenue growth, but at a low 5%. This is likely attributable to consumer behavior, however. Travel, dining out, etc. becoming easier in the second quarter of this year compared to the second quarter of last year, when the impact of the pandemic was greater, consumers spent less time at home and in front of their phones, tablets and televisions. So YouTube has faced some tough comparisons, and the fact that the business unit has still managed to grow revenue is a major plus, I think.
In the screenshot above, we also see that traffic acquisition costs increased 13% year over year, in line with revenue. So there hasn’t been any margin compression from that perspective, which is positive and indicates that margins are likely to remain healthy over the long term.
Alphabet, however, hired many more employees, which is why its workforce increased by 21%. It is not immediately clear why this is necessary for a business that is established and growing at a low rate. Alphabet’s management likely came to the same conclusion, which is why the company recently announced it would be slowing down hiring. The workforce data in the quarterly report is therefore negative, as GOOG failed to grow its revenue and gross profit faster than its workforce.
Operating leverage was therefore not a positive factor during the quarter. But the fact that management has come to the conclusion that hiring has been overdone in the recent past, and that this should change in the future, is a good sign. Investors can expect less headcount growth going forward, which should have a positive impact on Alphabet’s margins in the coming quarters, all else equal.
When we look through the income statement, we see that the large increase in headcount that we saw earlier has caused Alphabet’s operating expenses to increase significantly. R&D costs increased 27% year over year, while general and administrative expenses increased 20%. Increased R&D spending is currently hurting profits, but can be seen as an investment in the future. In the past, Alphabet’s investments have paid off, so I’m fine with increasing R&D spending, as this will hopefully translate into better future products that can expand the addressable market and GOOG’s revenue potential.
However, SG&A spending increasing by 20% is far from significant. When a company increases its turnover by 13%, administrative expenses should not increase further. In fact, they should ideally increase less, so that the company has operating leverage. This was not the case here. But if the pause in hiring has a significant impact on GOOG’s workforce growth, that trend may reverse in the coming quarters, and SG&A spending may grow less in the future. This would have a positive impact on Alphabet’s margins.
Another major contributor to Alphabet’s earnings decline was a significant movement in its other income/expenses. This line moved $3.1 billion against Alphabet from the prior year quarter. Given that the second quarter of 2021 was extraordinarily positive, this movement is not dramatic. And since that line doesn’t really reflect Alphabet’s underlying business performance, I don’t think investors should be concerned.
When we negate GOOG’s other income movement and adjust for its taxes, net income would have actually increased by $100 million year-over-year, or 0.6%. This is still significantly less than the less than ideal revenue growth rate, but we can still say that the decline in earnings can be attributed to the performance of other revenue/expenses over the period — the decline in profits is not the question of Alphabet’s core business. Underlying business growth remains healthy, and as long as management follows through on its workforce alignment statements, margins should increase again. So I think there’s a good chance that underlying earnings growth will be better in the quarters and years ahead.
Low valuation, excellent balance sheet and potential shareholder return
Alphabet has one of the best balance sheets in the world. At the end of the second quarter, cash and cash equivalents were $125 billion, excluding non-marketable securities. This equates to 9% of the current market value of the business. When we factor in Alphabet’s debt, net cash still stands at $110 billion, or 8% of the company’s market value, much better than the net cash position of 3% of Apple (AAPL), relative to its market value. Compared to Apple, which is widely regarded as a company with a very strong balance sheet, Alphabet thus has three times more cash reserves, adjusted to market value. Even in absolute terms, Alphabet’s net cash is 30% higher.
Alphabet’s Large Cash War Chest can be used in a number of ways. The company could introduce a dividend, but that doesn’t seem to be a priority at the moment. Acquisitions are another option, although they should only be pursued when the price is right and when there are no antitrust concerns. I believe that one of the best ways for Alphabet to spend its money is through its share buyback program, because these increase each share’s share in the total company, and since there is no risk regulatory or enforcement. Management seems to agree, as Alphabet spent heavily on buyouts during the quarter. According to its earnings release, Alphabet spent $15.2 billion on buybacks during the period, or just over $60 billion annualized. At this rate, the company can buy back about 5% of its shares per year, which has a significant impact on the growth rate of its earnings and cash flow per share. In fact, this is a faster repurchase rate than Apple’s historical repurchase rate (around 3% to 4%), and Apple’s repurchases are widely considered a key driver for its total returns. convincing.
With Alphabet able to repurchase shares even more aggressively, great shareholder value could be created in the long term as long as GOOG maintains its repurchase pace. With GOOG generating $16.5 billion in free cash flow in the last quarter, these buyouts are easily funded. In fact, despite this compelling redemption pace, Alphabet actually added even more money to its net cash position. This would allow the company to further increase redemptions, as there would be no problem if its net cash decreased over time.
Looking at Alphabet’s valuation, we see that the stock is currently trading at 19x free cash flow (T2 annualized) when we adjust Alphabet’s net cash position. This is, I believe, appropriate. In other words, Alphabet is trading at a cash-adjusted net cash yield of just over 5%, which is a pretty attractive valuation for a company with a strong moat, tailwinds to growth, high-potential business units such as Waymo, and when we take into account the strong growth of Alphabet’s underlying business of 13% in the most recent period.
Not everything has been great in the last quarter. Hiring was apparently overdone, as headcount grew too much relative to the company’s growth rate. This hurt Alphabet’s margins during the period. But it seems that the management wants to correct this error in the future.
GOOG’s revenue was down from the second quarter of 2021, and results missed estimates on both lines. Of course, that’s not great. But the decline in profits is attributable to other revenue/expense movements, and the shortfall was not too great.
I think Alphabet is a very solid company with a positive long-term outlook, and the current valuation is attractive. I also believe there is a good chance that investors will be satisfied buying at current cheap prices, especially when management goes all the way with its headcount adjustments which should once again improve margins. In the meantime, buybacks should add significant value for shareholders as long as they are made at current low-cost prices.