Interactive Investor

Stockwatch: look no further than this amazing tech giant

30th July 2021 11:22

Edmond Jackson from interactive investor

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Our companies analyst has one of the world’s biggest technology companies in his sights this week following publication of latest results.

How significant are bumper second-quarter 2021 results from Alphabet Inc (NASDAQ:GOOG), owner of the multifarious Google operation and Android smartphone operating system? 

Revenue has soared 62%, or 57% at constant currency to $61.9 billion, a near 11% beat on consensus for $56 billion.

Cost of revenue rose 41% and operating expenses by 22%, but they still meant an excellent operating margin of 31% which flags a business to prioritise.

$18.5 billion net income meant earnings per share (EPS) of $27.26 versus $19.14 expected, a massive 42% beat.

Yet the stock has been flat around $2,730 in response, as have Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL), which also beat expectations – if not to quite the same degree. 

This is nearly 2% off Alphabet’s 27 July all-time high and the trailing price/earnings (PE) is around 29x versus same for Apple and 36x for Microsoft.

These charts are all a near-perfect parabola: Alphabet began to rise in 2012 from $300 and accelerated with the onset of Covid from $1,400 to a recent high of $2,780. 

You could say the market is broadly efficient here: respecting very strong competitive positions for these tech behemoths, fat margins and likely resilient customer demand going forward.

PE multiples are full but nowhere near as distorted as during the 2000 tech bubble.

Yet an adage also says that when bull market leaders no longer respond to earnings beats, in particular, it signals a stale market.

Right now, those who want to buy equities have substantially done so but are edgy to protect gains after stocks have enjoyed a big boost from monetary stimulus; moreover, US inflation has breached 5%.   

A genuine re-rating is under way

The second quarter of 2020 saw Alphabet’s first-ever year-on-year revenue decline as Covid disrupted growth and advertisers pulled spending.

It was only a 2% easing but yes, “advertising” remains the key revenue driver and relates to the overall level of commercial activity hence is strictly cyclical. 

Prior to that, it had been easy to brush aside cyclical concerns while Google had capitalised on a one-off shift from traditional commerce to online.

Yet Google is now so pervasive in modern life and is radically advancing Artificial Intelligence (AI) in support of functions that serve essential daily needs: such as Drive for cloud storage, Play for App developers and users, Maps for navigation, YouTube for entertainment and Workspace for enterprise needs.  

The table shows Google Search as the predominant revenue contributor at 58% compared with 56% a year before, then YouTube ads at 11% and Google Network at 12%. 

While Cloud is entertained as a long-term growth driver, as yet it represents just 7% of revenue and a £0.6 billion loss if down from a $1.4 billion loss in 2020. 

In operating profit terms, Alphabet is therefore wholly reliant on Google Services which contributed $22.3 billion for a net operating profit of $19.4 billion.

Retail is also by far the largest contributor to growth of advertising; with travel, financial services, media and entertainment also significant.

Yet I believe this does not constitute a high risk because Google is radically more effective than traditional marketing, for most businesses.

The pandemic has more likely re-rated Alphabet’s financials than provided a one-off boost.

Furthermore, just over half the group’s revenues derive outside the US which puts Google in a powerful position internationally as developing countries expand their internet coverage.

On a genuine long-term view, it seems possible to argue “anytime” is a good time to accumulate Alphabet stock.

Longer-term risks of regulation check Google’s strength

Such a stronghold on “infrastructure of the internet” recalls lessons of investment in 19th-century mining booms, when it proved far better to invest in picks and shovels than take the risk of mining itself.

The flip-side is becoming a target for anti-trust regulation in the US, meanwhile governments experience frustration low rates of tax being paid – for example criticism in the UK that Alphabet “writes its own rules” on taxation.

Alphabet’s stance is it paying what tax is due in other countries alongside 80% of its tax in the US as its home country.

Cynics may dismiss the “picks and shovels” argument given the same was said about Cisco Systems (NASDAQ:CSCO) in 1999-2000: that its routers, switches, software and services were a key enabler of the internet. Its stock then slumped from a $77 high near $10 and 21 years later trades at $55.

Yet in March 2000, Cisco’s trailing PE approached 200x which was overblown. 

A market-specific risk would be a general de-rating of more highly-rated stocks if inflation becomes ingrained. This economic risk currently coincides with an edgy balance of investors in the stock, so yes, the next few months could be tricky – or conceivably generate another buying opportunity.

Alphabet Inc - segmental analysis

  Quarter ended 30 June
Revenue: $ millions 2020 2021
Google Search & other 21,319 35,845
YouTube ads 3,812 7,002
Google Network 4,736 7,597
Advertising total 29,867 50,444
Google other 5,124 6,623
Google Services total 34,991 57,067
Google Cloud 3,007 4,628
Other bets 148 192
Hedging gains/losses 151 -7
Total revenue 38,297 61,880
     
Traffic acquisition costs 6,694 10,929
     
Number of employees 127,498 144,056
     
Operating income:    
Google Services 9,539 22,343
Google Cloud -1,426 -591
Other bets -1,116 -1,398
Corporate costs -614 -993
Total income from operations 6,383 19,361

Promising qualitative aspects within Google Services

Items within the earnings call underline Alphabet’s grip.

Management cites a rising tide of online consumer and business activity; record revenues also for publishing partners (over $120 billion earned altogether by developers, globally, within Google Play); record traffic to third-party websites, also billions of direct connections such as phone calls, directions, ordering food and making reservations. AI will in due course enhance all this.

“Multi-task Unified Models” constitute a big advance in Google Search offering capability across 75 languages – hence ability to source in one language and yield information in another. As is

“Lambda” which achieves a new level of natural conversation capabilities, making information and computing more accessible.

Android 12 is due release soon, offering new ways to personalise devices and significantly improve speed/power efficiency; with new in-built privacy protections.

Cloud revenues are up 52% year-on-year, helped by new products. Organisations such as PayPal, Johnson Controls and Whirlpool have deployed their SAP software solutions on Google Cloud.

It is said also to benefit from expertise in real-time data and analytics, as a differentiator from the competition.

New solutions against cyber and ransomware attacks were launched at a recent Cloud Security Summit, with BT and Adobe bringing some of these to market.

They are said also to be helping strong growth for Google Workspace, enabling client wins such as Carvana, the online auto retailer, and Red Hat software.

YouTube is rolling out Shorts, a new short-form video experience that has just surpassed 15 billion daily views; and good progress with subscription products across music and TV.

Buy the dips, if identifiable

Hopefully, this gives you an “essential case” overview, why I believe Google is set to remain a long-term quality growth stock – and increasingly among international portfolios. 

Yes, there is short to medium-term downside risk in a rather tired technical situation for big tech stocks, if inflation means tighter monetary policy.

With fresh money therefore, you might wait and see – or vainly hope – if the second half year onwards might generate a better buying opportunity than near an all-time high.

But with an operating margin over 30%, I do not envisage the PE rating contracting much unless there is an anti-trust assault. Overall: Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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