Google: Value Hiding in Plain Sight?

In its simplest form, I view Google as the “gateway” to the internet. The company’s core search tool is one of the most relied upon utilities in the world, processing 3.5bn searches per day. It’s creation has truly revolutionised the way human beings access information and has made us incredibly more efficient. In addition to search, Google has six separate products with over 1bn users including Chrome, YouTube, Gmail, Google Maps, Google Play Store and Android (which just hit 2bn active devices).

In most cases, Google’s products are superior to alternatives (particularly in search) and offer an incredibly high value proposition for users. When combined with the fact that they are generally free, their mass adoption seems logical.

  • Search is essentially a monopoly with around 90% share across desktop and mobile
  • Chrome is the number one browser for both mobile and desktop with 54% share
  • Android is the leading operating system for smartphones globally with 86% share

Google’s Edge

I believe the company’s success can be primarily attributed to three core advantages: culture, mindshare and data. From the outset, Larry Page and Sergey Brin have always been focused on solving big problems and creating an incredibly valuable user experience. Their initial motivation was not driven by an interest in selling ads, but rather their mission to better organise the world’s information. They have always sought the best talent and had an ability to think in terms of decades, not quarters. I believe the importance of corporate culture is often overlooked and in Google’s case is extremely valuable and difficult to replicate. It has enabled the company to stay on top for the last 20 years and build up significant brand equity (Google is currently estimated to be one of the worlds most valuable brands). This is crucial for an online technology platform such as Google. The assumed superiority of Google’s search tool, and the associated decision to use it, are effectively subconscious thoughts. I believe that Google’s mindshare and user search habits will prove very difficult to change overtime, and in effect, provide huge barriers to any competitor in the search arena. These barriers are further strengthened by the firm’s data advantage. In essence, each additional user for search (and also Google’s other products) widens the moat, as more users means more data. This allows Google to further improve their products and deliver even greater value for users. I think of this as a data feedback loop and believe its helps explain why competitors have not been able to make a dent in Google’s market share. After years of effort and billions of dollars spent by Microsoft, Amazon and others, there still remains no acceptable substitute for Google. It’s also important to understand that Google’s dominance in browsers (Chrome) and mobile operating systems (Android) were, and still are, key to protecting its competitive position. By becoming the market leader in these areas Google effectively captured users entry points to the internet and enabled Google search to be provided as the default option.

The Ad Market

In 2017, the global advertising market was circa $580bn, with digital advertising making up ~40% at $230bn (up 21% YoY). Looking at these numbers it’s clear that Google is already capturing a large piece of the pie (~44% of digital ad spend comes their way). To me this is not surprising. Google’s ability to mine data across its properties makes it the most effective advertising channel in the world. By creating targeted ads that result in better conversion rates for advertisers they become the number one option online. I believe that the shift from traditional to digital will continue at a healthy rate and as more commerce shifts online (particularly in EM countries) additional advertising spend will follow suit. Whilst I acknowledge that digital ad growth will likely moderate from its recent 20%+ growth rates, I think it will remain well above average for many years to come. This will enable Google to grow larger and for longer than the market currently anticipates.

Valuation

So, what are you paying today for the search business? In my opinion, not much. At first blush, the company appears somewhat expensive, trading at 26x 2018 earnings. However, there are a number of things going on behind the headline multiple.

Lets start with the $43 in earnings that Alphabet is expected to generate this year. This includes ~$4.7/share of investments in what they refer to as “other bets”, that is Waymo (autonomous cars), drones, health care and AI etc. In my mind, the fact that it’s simply expensed through the income statement means that the current financials understate the true earning power of the current business. As we move forward, either these “other bets” will emerge as viable businesses or they will simply be terminated. Hence, I view normalised earnings as closer to $47/share.

Then let’s go to the balance sheet side. Firstly, the company is by no means short of cash and come the end of this year will have ~$150/share in cash. Then we have YouTube, a remarkable business in its own right. If we were to value YouTube in a similar fashion to a traditional cable company (i.e. at 80c per hour viewed), we would come to a valuation of $550 per share. As a point of reference, Netflix is currently value at ~$3.30 per hour viewed. But to be extra conservative, let’s apply a 50% haircut and assume YouTube is only worth $275/share.

So… bringing this all together. The market is currently asking me to pay $1,100 per share for Alphabet. This gets me $150/share in cash and conservatively $275/share with YouTube. That’s $425/share of value that contributes a trivial amount to current earnings. Stripping that out of the stock price, and I’m paying $675 for Google’s core business that will earn ~$47/share this year. That is a PE of just 14x. This is remarkably cheap and well below other dominant companies with durable franchises that are growing at 20% p.a.

In my view, Alphabet is incredibly cheap and provides investors with an opportunity to own one of the worlds most successful and innovative founder led companies with an extremely strong competitive position. I believe the company has the ability to compound its intrinsic value (earnings power) at 15%-20% over the next few years with minimal risk of disruption.