Investors who purchase growth stocks do so for the potential for significant returns. These stocks often don’t pay a dividend, as the companies usually reinvest profits back into their business. This helps the companies continue to expand.
Dividend growth investors often ignore these stocks because of this fact. Some growth stocks produce a robust amount of cash that they shouldn’t be completely ignored by these types of investors. We feel that Alphabet (GOOG, Financial)(GOOGL, Financial), better known as Google, is one company that income investors should consider.
Company background
Alphabet is the parent company of Google, the largest Internet search engine in the world. Alphabet holds all of the company’s business under one roof, including the Google search platform, YouTube, Android, Chrome and others. Google is Alphabet’s largest source of revenue, which come primarily from targeted advertising sales. Google has become synonymous with internet search, helping to give life to the phrase “Just Google it.” Alphabet is also one of our favorite social media companies.
Alphabet generated nearly $111 billion in sales in 2017. Total company revenues are almost evenly split between the U.S. (47% of last year’s revenues) and international markets (53%). This makes Alphabet a truly global company. Alphabet has a current market cap of $725 billion, making it one of the largest companies in the world.
Alphabet consists of two separate classes of shares. The "A" class, GOOGL, holds voting rights while the "C" class, GOOG, does not. All references to Alphabet in this article are to the "C" shares.
Recent financial results
Alphabet reported financial results for the third quarter on Oct. 25. The company earned $13.06 per share, an increase of more than 36% from the same quarter a year ago. Earnings per share topped the analyst average estimate by $2.65, a massive beat. Revenue increased 21.5% to $33.74 billion, though this was $310 million below what the market expected. This was the lowest percentage increase for revenues since the second quarter of 2017. The average sales increase over the last nine years is 23%. A lower effective tax rate (9% versus 16% in the third quarter of 2017) contributed to the company’s bottom line. The market disliked the sales miss and sent shares lower following the result release.
Advertising revenues, which represent the core of Alphabet’s Google business, totaled $24.1 billion, slightly below estimates of $24.3 billion. Still, this was a 22% year-over-year improvement. Google Network Members’ properties, which gives advertisers control of which Google platform to place their ads, improved 13% to $4.9 billion.
Traffic acquisitions costs, or TAC, were $6.58 billion, a 20% increase from the previous year, but below consensus estimates of $6.75 billion. TAC costs represented 23% of revenues, the same as the third quarter of 2017. Paid clicks for Google Network Members’ properties increased 62%, above estimates of 56.7%. Just as important, cost per click declined 28%, topping an expected decline of 21.3%. This means that Alphabet had to spend less than expected to drive traffic to their products.
While the market may have disliked the company’s revenue miss, Alphabet still showed more than 20% growth in this area. Recent results, however, are not why investors should buy or sell the stock.
Uses for cash
Alphabet’s GAAP operating income was $8.3 billion during the quarter, falling short of expectations of $8.5 billion. GAAP operating margin matched estimates at 25%. Even though Alphabet missed on operating income estimates, the company remains very profitable and is one reason investors should consider the company.
Alphabet had at the end of the third quarter a total of $119 billion in cash and equivalents, marketable securities and long-term investments on its balance sheet. Only a few other companies in the world can match or exceed this cash hoard, but this total represents just 16.4% of Alphabet’s current market cap.
In addition, Alphabet’s cash flows are improving. For the quarter, net cash increased 34% while year-to-date net cash is up more than 30%. This cash can be used to repurchase shares, something that Alphabet has been very active in doing. The company bought back $2.2 billion worth of its own stock in the third quarter, bringing its total repurchases for 2018 to $6.4 billion. Alphabet has a current repurchase authorization of more than $8 billion for the year.
Many technology companies offer employees stock-based compensation as a way to attract and retain talent. While this can keep and motivate the best employees, this form of compensation can also increase the share count and dilute earnings. Alphabet saw stock-based award activities of $1.25 billion for the quarter. This total now stands at almost $4 billion for the year. Still, share repurchases have more than made up for stock-based compensation, reducing the amount of dilution to earnings.
Besides share repurchases, cash can be used to buy businesses that can add to Alphabet’s growing umbrella of companies. The company has made hundreds of acquisitions in the last decade. Alphabet attempts to purchase companies that help improve consumers' lives to the extent that they use them on a daily basis. For example, the company agreed to purchase Nest Labs for $3.2 billion in January of 2014. Nest Labs provides “smart” appliances for consumers’ homes, such as thermostats and smoke detectors that can connect to smartphones. Allowing consumers to adjust the temperature or detect fires from their phone is something that many people would find enticing.
Not all purchases are of the large variety either. That doesn’t mean that smaller purchases aren’t important to Alphabet. The company’s most recent acquisition for Sigmoid Labs was announced just last week. Sigmoid Labs provides India with the popular transportation app “Where Is My Train”. The app has roughly ten million registered users. India operates nearly 14,000 trains every day. Though terms were not released, it is likely that Alphabet paid $30 to $40 million for the company. For this price, which represents a tenth of one percent of third quarter sales, Alphabet gained a widely used app in a country with more than 1.3 billion citizens. This gives the Alphabet even further access to India.
Having such a large cash position should allow Alphabet to continue to make both big and small acquisitions in the future. The amount of cash that the company holds likely means it cannot be outbid for a business that it likes. This should allow Alphabet to continue to grow its reach.
Valuation
The average analysts’ EPS estimate for 2018 is $41.78. Based off of Friday’s closing price of $1042.10, shares trade with a price-to-earnings ratio, or P/E, of 24.9. Value Line says that shares have had an average annual P/E ratio ranging from 19.1 to 27.6 from 2008 through 2017. The average valuation over that time is 23.9x earnings.
While shares are slightly more expensive than their historical average, they are not excessively so. Up until recently, the S&P 500 traded with a P/E ratio of more than 20, though the current valuation of the index is below this level.
While some investors might avoid a stock with a valuation elevated against both its own history and that of the market, Alphabet has increased EPS by a rate of 18% per year over the last decade. If it hadn’t been for a 10% increase in the share count from 2008 through 2017, this earnings growth rate would be even higher.
Conclusion
Alphabet doesn’t pay a dividend, making the stock an unlikely pick for dividend growth investors. Though the company pays no income, it’s earnings growth rates and cash balances could be appealing to investors who are not living off of dividends at the present time. Alphabet’s earnings growth rates and its ability to purchase almost any company it targets should help grow the company into the foreseeable future. With shares down slightly more than 2% for the year, we recommend investors not requiring income at the moment consider adding shares of Alphabet to their portfolio.
Disclosure: I am not long any of the stocks mentioned in this article.
