The 5,099,019,513.59 Reasons to Buy Alphabet Stock

Alphabet (GOOGL, Financial) is the new holding company that holds Google and businesses that were previously part of Google but are separated under the new entity.

Google is a technology company that wants to make information accessible to users. The vast majority of revenue and profits are coming from Google’s search business. Its search ad business is extremely profitable and fast growing. The company is controlled (through voting stock) by the two founders and their former CEO; Larry Page, Sergey Brin and Eric Schmidt. Because of their large stake in the company, all three are extremely well incentivized to see the company do well.

The voting share class gives the company’s management the ability to invest for the long term and that is what they do. This has frustrated powerless minority shareholders, like myself, in the past. Although the core business is throwing off cash, the investments by this team did not always make sense. However, as these investments are starting to pay off, they are getting more credit for their insight. Google has spent at least $23 billion buying companies over the past 10 years. Successful (large) acquisitions include Google buying YouTube for $1.65 billion, DoubleClick for $3.2 billion, Android for $50 million. If we had any way to calculate the ROI of Android it is fair to say it would be insanely high. The Motorola acquisition is kind of a bust. Google bought it for over $12 billion and subsequently sold it for $3 billion two years later. True, they kept the patent portfolio and this helps them in patent wars, but is that worth $9 billion?

Although Page, Alphabet's CEO, is not a charismatic media presence, slowly over the years we are learning more about him and what his interests are. The past few years he has appeared to become more interested in the art of investing and capital allocation. Of course there are the founders' letters which have demonstrated an interest in Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) from the get go, but with the launch of Alphabet another interesting letter by Page was made available: G is for Google. It includes this key paragraph:

For Sergey and me this is a very exciting new chapter in the life of Google — the birth of Alphabet. We liked the name Alphabet because it means a collection of letters that represent language, one of humanity's most important innovations, and is the core of how we index with Google search! We also like that it means alpha”‘bet (Alpha is investment return above benchmark), which we strive for!

What is important is that Page commits himself to beating “the benchmark." The founders aspire to many things. including lots of incredible changes for the better, sometimes referred to as moonshots. I do not know if the billions the company throws there will pay off, but if you are CEO of a company, not to mention a fairly intelligent guy, that includes the Google core business, and you want to beat the market, you can. Actually, I think he should trounce it.

Trouncing the market is a good thing in and of itself, but as the EMH (efficient market hypothesis) states that outperformance should come at the expense of running a lot of risk at the same time. If it does, I am too stupid to see it. The company has very little debt and a huge cash balance of $73 billion. That is more than three times what the company has spent on acquisitions in the past 10 years. The company is providing an essential service that is highly beneficial to the lives of people and the economies of the countries where it is provided. Sometimes bears argue switching costs are low, and users could instantly defect to another search engine. That fear is vastly overplayed. The company has a dominant market share in search. Both on desktop and mobile and every time a user searches on Google it is proving the company with a data advantage against (future) competitors. The most useful data in providing the highest quality search results is the searcher’s search history. Nothing you put on LinkedIn (LNKD, Financial) or Facebook (FB, Financial) can compete with that. The only real risk here is that the company makes terrible acquisitions, bad investment decisions or behaves in otherwise shareholder unfriendly ways. Since ex-Morgan Stanley’s Ruth Porat has come in as CFO the company is showing that it wants to be more shareholder friendly in the future not less. Did I mention the $5,099,019,513.59 stock buyback?

Because the company is growing rather fast – its 10-year average EPS growth is roughly 40% – it is hard to overpay. As value investors, that is of course our biggest fear. The stock is incredibly popular with gurus; Mario Gabelli (Trades, Portfolio), David Tepper (Trades, Portfolio), Mohnish Pabrai (Trades, Portfolio) and Tom Gayner (Trades, Portfolio) all own shares, so they seem to think it is not expensive.

A good way to look at Alphabet’s value (since its value is still mostly driven by Google) is by looking at Enterprise Value/Ebitda. At the present it trades at 18x, but if you take into account how it develops that is at least a fair price; if Page is really serious about driving ROE he can easily drive this by increasing debt somewhat and putting the dead cash to work. That would dramatically alter the EV/Ebitda multiple and boost ROE. Google has been a top three position for me all year and after the recent runup, it is the largest, but I intend to keep it that way for the foreseeable future and possibly buy more as the company is becoming more shareholder friendly as evidenced by the landmark buyback. It is going to be interesting to see how opportune or foolish this buyback is going to look in hindsight.