David Rolfe Comments on Alphabet

Alphabet’s (NASDAQ:GOOG)(NASDAQ:GOOGL) core Google subsidiary continues to show accelerating growth, driven by YouTube advertising and share gains in Google Cloud Platform (GCP), with the latter competing against Microsoft Azure and Amazon’s AWS. 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. 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. 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. 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.

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. 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. Last, we think Alphabet’s “Other Bets,” which represents a gaggle of non-core, 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.

From David Rolfe (Trades, Portfolio)'s Wedgewood Funds fourth-quarter 2019 shareholder letter.

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