“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” — Warren Buffett, Fortune, 1999
Alphabet, Google’s parent company, is trading so cheaply even after Thursday’s strong earnings report that only three things can explain it:
- The government will soon force Alphabet to materially alter its business model or break up entirely;
- The company has lost its competitive fire and resembles a think tank more than a profit-maximizing enterprise;
- The stock is misunderstood and misvalued.
I believe it’s Door #3 – and Alphabet is my fund’s second-largest position, so I’d better. In fact, I believe that Alphabet is one of the most widely misunderstood and most undervalued companies in the world. It’s a classic early-21st-century value stock, one whose core search business is a dominant franchise with years of growth ahead that’s selling for roughly the same multiple as General Motors.
‘Headline risk’ at Alphabet
Let’s begin with the headlines. Earlier this year the Trump Administration lined up the nation’s major tech platforms, including Google, for regulatory scrutiny. This has pleased both economic populists and some free marketeers, who have formed an odd coalition asserting that the Big Four are this century’s equivalent of the meatpacking, railroad, tobacco and oil monopolies of Teddy Roosevelt’s time a hundred years ago. The arguments both pro and con are complicated and somewhat impenetrable; from an investment perspective, however, they are largely and thankfully irrelevant.
A leitmotif of this column will be that what’s in the news almost never correlates with what’s critical to the drivers of long-term value. Because it’s front-and-center, the chatter is always loud, but rarely material – noise rather than signal. Investors have a term for this – “headline risk” – and when an otherwise healthy, long-dated enterprise is facing headline risk it’s often an ideal time to buy.
I believe that the government’s current antitrust scrutiny of Google is the very definition of headline risk, for two reasons. First, if the government’s remedy is more regulation, the historical record is clear: More regulation merely entrenches incumbents. This is because every new rule and restriction raises the barrier to entry for potential disruptors. Major banks, for example, are thriving today under the 850-page Dodd Frank Act, which according to law firm Davis Polk & Wardwell required that federal agencies promulgate more than 300 new rules, studies and periodic reviews. How can fintech disruptors hope to navigate such a regulatory thicket?
The same is true in tech, as Google itself found out last summer when the European Union introduced new privacy laws intended to protect consumers. Smaller sites found they couldn’t comply with the new standards, so Google’s market share increased. De-regulation is what big business fears, and rightly so, because it lowers barriers. When rules governing the airline and stock-brokerage industries came down decades ago, innovators like Charles Schwab and Herb Kelleher of Southwest Airlines were free to compete against fat oligopolists like Smith Barney and Trans World Airlines.
Should the government decide that regulation is too moderate a course and a more radical breakup is required, this too represents a “throw me in the briar patch” moment for Alphabet. The company suffers from a conglomerate discount, with its parts worth more than the whole is currently trading for — and much of this is Alphabet’s own fault.
The benefits of a breakup
The crux of it is that Google’s core search business is so profitable that the rest of Alphabet’s many subsidiaries are freeloading off it. Everyone knows that the company’s “other bets” is a collection of money-losing moonshots. What’s less well-understood is that ex-search, all of Alphabet’s other businesses taken together lose money. These losses aren’t apparent because powerful emerging platforms like YouTube, Android/Google Play, Cloud, Waymo and Assistant are grouped in the company’s financial statements under the general Google umbrella. This obscures any insight into their profitability. However, I and other analysts have concluded that if you assume reasonable profit margins for core Google search, these other emerging businesses collectively lose $5 billion a year. That’s a huge number, equivalent to the annual profits of Adobe and Intuit combined.
Despite Alphabet’s attempts to obfuscate, the market is catching on, as markets tend to do. Even after Friday’s 10% upward move following a solid earnings report, Alphabet’s stock is down from where it stood a year ago, badly trailing both the broader market and the shares of the other tech giants teed up for regulatory review.
If the government mandates that Alphabet break up, the company’s many freeloading children would have to take care of themselves. Forced to generate profits, they would flourish, and the value of Alphabet’s parts would multiply. Here again, there are historical antecedents. After Standard Oil’s 1911 breakup, the antitrust headline risk risked ebbed away, and investors got a clearer picture of the asset-rich nature of Standard’s various parts. Standard Oil of New York more than doubled in value over the following year, and Standard of Indiana nearly tripled. Taken together, according to Ron Chernow’s excellent Rockefeller biography, Titan, the broken-up entities quintupled in value in the decade after the breakup.
Many argue that Google search is so good, and so profitable, that it does more than subsidize Alphabet’s money-losing ventures: It enables a dysfunctional “cool first, execution second” culture. Amazon, these critics say, focuses ruthlessly on dominating a few, large markets – e-commerce and back-end web services. Apple has sold an iPhone to about everyone who can afford one; now it sells high-margin services on this platform and uses every dollar of profits to buy back stock. Alphabet, by contrast, spends money like a new-age drunken sailor. It has no timetable for commercializing anything but search, and it retains more than $120 billion of cash on its balance sheet. Many of the company’s endeavors seem like glorified science-fair entries; take the aptly named Project Loon, whose mission is to deliver universal internet connectivity via a network of high-altitude balloons. “Too much R, not enough D” – “Bell Labs without the transistor to show for it” — these are the kind of complaints now being thrown around on Wall Street about Alphabet, especially in the hedge-fund community, where performance is measured on a 12-month scale.
Search reigns supreme
I am sympathetic to these arguments, which is why I think a breakup would yield a higher valuation. In the end, however, it is Google’s core search engine that represents the alpha and omega of both understanding and valuing Alphabet. Yes, the company spends money like a drunken sailor. Yes, its culture is not nearly as mercenary as the dread pirate Bezos and his band of Amazonians. But Google search is possibly the best business ever invented, and that outweighs all other concerns. It reminds me of what Lincoln is reported to have said after taking an informal vote among his cabinet in which he cast the only vote in favor: “Seven nays, one aye – the ayes have it.”
Why is Google perhaps the best business ever invented? Most importantly, it is virtually impossible to replicate its search engine, which people around the world use roughly four million times per minute. Microsoft lost billions trying to challenge it with Bing. Amazon also tried to compete in web search, giving up after the project leader left to join Google. “Treat Google like a mountain,” Bezos is quoted as saying in The Everything Store. “You can climb the mountain, but you can’t move it.”
Because of this, Google is synonymous with search and has a more than 90% market share. Any service business that wants to advertise online must pay Google for access to potential customers. A 2017 Bloomberg Businessweek article brought Google’s power home through an in-depth look at a single niche of the US economy, drug-treatment centers. The article described how shady clinics paid high prices for Google keywords to lure addicts into questionable facilities. The bidding for terms like “top drug rehab center” became so competitive that one rehab executive estimated that his industry was spending $1 billion a year on Google search advertising.
Google has since taken steps to curb abuses in rehab-center search, but the point holds: Every company in every service industry, from rehab centers to veterinary clinics to divorce lawyers, will continue to bid up critical keywords until these businesses barely earn their cost of capital. It’s therefore not surprising that industry analysts estimate that Google search has 5%-10% annual pricing power, far in excess of the overall economy’s 2% inflation rate. There is room for Google to grow volumes as well. While many people intuitively believe that Google search is somehow mature because it’s already so big, the fact is that online today captures only 20% of total global advertising and marketing spend. Add to this the fact that Google search is a software enterprise that requires little incremental capital and little incremental operating expenditure to grow and you have a true 21stcentury juggernaut.
How much is it worth? A lot. Alphabet’s reported operating margins are just under 25%, which clearly understates search’s profitability. Facebook and Alibaba, two other Internet giants with scalable software businesses like Google, report margins in the 40%-50% range. If we add back $3 billion of Alphabet’s “other bets” losses, the company’s margins rise to 35%. If we add back the $5 billion of estimated losses from emerging platforms like YouTube and Google Cloud, search margins fall out at 40%-45%, much more in line with its peers.
Using these adjusted margins, when you buy Alphabet at $1,250 a share you are getting core Google search for less than 20 times its 2019 earnings. This is an absurdly low price for a business of its quality. Things become even more nonsensical when you contemplate that this analysis gives zero value either to the $120 billion of cash on Alphabet’s balance sheet or the value of emerging platforms like Waymo, YouTube and Google Cloud. While these businesses are breakeven or loss-making now, that won’t last forever. If one assigns reasonable valuations to each of these currently profitless enterprises, investors can buy core Google search for eight times this year’s earnings. That’s about the same price you’d have to pay for General Motors, a cyclical, capital-intensive, commodity businesses whose best days are fast receding in the rearview mirror.
As time goes by, I think we’ll look back on mid-2019 as a great entry point for owning Alphabet. Fear of increased regulation is giving us headline risk. Headline risk, combined with Alphabet’s lackadaisical approach to everything but search, is giving us a depressed valuation. The price is so cheap relative to the quality of Alphabet’s businesses that any scenario — more regulation, an outright breakup or simply better execution on Alphabet’s part – should almost certainly generate excellent long-term results.
Adam Seessel is founder and CEO of Gravity Capital Management. Alphabet is his fund’s second-largest position. His column, “Valuation,” appears monthly on Fortune.com.
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