Google Q2 earnings miss, spectacular risk/reward bet for bulls

Alphabet’s Q2 report saw the company miss on both top and bottom lines, with revenue and EPS coming in at $69.69B (vs. est. of $70B) and $1.21 (vs. est. of $1.29). However, these numbers were better than feared, considering some of the grim economic outlooks we have been hearing from other companies (as Alphabet’s misses were only marginal). As of writing, Alphabet’s stock is climbing +5% to trade at $110 per share.

Market seems to be taking a glass-half-full approach with Alphabet’s Q2 earnings (after all, Alphabet’s advertising business is doing pretty well compared to the likes of Snap (which just blew up in Q2)), and I agree with this stance.

In this note, we will analyze Alphabet’s Q2 report and re-evaluate its fair value in light of this new earnings data. Furthermore, we will explore Alphabet through the lens of quantitative and technical data to gauge the current price as an entry point. Let’s begin.

Analyzing Alphabet’s Q2 Report
In Q2 2022, Alphabet’s revenue came in at $69.69B, up 12.6% y/y and slightly below consensus analyst estimates of $70B. Given the economic uncertainty faced by corporate America, Alphabet’s marginal miss is not bad at all (especially when y/y growth rates were impacted by 3.7% due to foreign currency movements). While the revenue miss is only marginal, Alphabet’s operating margins fell by 300 bps y/y, and this is concerning because my bull thesis for Alphabet is built around operating leverage.

During the Q2 earnings call, Alphabet’s CFO, Ruth Porat, pointed toward headcount growth as the primary driver of higher R&D (and operating) expenses. While the management remains committed to long-term growth, Sundar Pichai’s (Alphabet CEO) message for sharpening focus at the company was loud and clear. As you may know, Alphabet recently paused hiring for a couple of weeks, and in my view, Alphabet’s management is already working towards higher operating margins. If the economic downturn were to transform into a deep recession, Alphabet may cut jobs later this year and in 2023; however, for now, the company intends to hire in areas of strategic importance (long-term growth drivers like Cloud, AI, etc.).

Despite growing fears about the economy, Alphabet’s advertising business outperformed expectations, with ad revenues coming in at $56.3B. The strength in Google Search performance was more than enough to offset the weakness in YouTube and Google Network ad revenues (where some advertisers pulled back on spending). Additionally, Google’s Cloud business grew at 35% y/y during Q2.

Overall, Alphabet’s revenue growth of 13% y/y is healthy. Considering the current macroeconomic & geopolitical environment in conjunction with Alphabet’s tough comps from last year, Alphabet’s ability to grow at a double-digit rate is truly exceptional. While revenue growth may continue to moderate over coming quarters (due to tough comps), I fully expect the company to moderate double-digit growth rates for years to come.

For me, Alphabet is not a revenue growth story but an operating leverage story. Hence, the flattish operating income in Q2 2022 is painful. Alphabet is experiencing significant margin volatility due to extrinsic macroeconomic events, and these will normalize in due time. Over the long term, I see Alphabet’s operating margins at 35%, with FCF margins climbing up to 30% (current TTM FCF margin: 25.5%).

During Q2, Alphabet recorded a positive free cash flow of $12.5B on the back of healthy revenue growth, which was offset somewhat by weaker margins. With expenses currently growing faster than revenues (24% vs. 13%), Alphabet’s free cash flow margins may remain under some pressure in the near term. However, the dollar amount (of free cash flows) will likely keep rising in unison with revenue growth over the coming years.

As you can see above, Alphabet’s net income and operating cash flows fell by 13.6% and 11.3%, respectively (in Q2 2022). During the last quarter, Alphabet’s free cash flow contracted from $16.4B in Q2 2021 to $12.5B. However, if we look at TTM figures, then Alphabet is still producing greater amounts of free cash flow than a year ago period. In the last twelve months, Alphabet has produced roughly $65B in free cash flows, and Q2 dip is just a temporary blip.

We have previously discussed Alphabet’s cash hoard at length, and it is this financial strength that’s allowing the advertising giant’s management to spend $15B on share repurchases during a quarter where the company’s free cash flows were down to $12.5B. In April 2022, Alphabet’s board approved an additional $70B to its buyback authorization, which already had ~$4.1B at the end of March 2022. During Q2, Alphabet spent ~$15B on share repurchases, which leaves ~$59B on the buyback authorization.

Alphabet is a free cash flow machine, and despite the snag in Q2, I expect it to generate tons of free cash flow over the upcoming quarters (and years). As you may know, Alphabet is an incredible business with strong moats in multiple trillion dollar markets, including digital advertising and cloud computing. While Alphabet’s revenue growth rates are unlikely to match what we saw from the company in 2021 (ever again), I think it is fair to assume healthy 10-15% annual sales growth for Alphabet over the medium term.

Due to heightened fears of a recession, Alphabet has been experiencing a painful normalization in trading multiples over the last six to eight months. As of today, the company trades at just ~21x P/FCF, which is the cheapest Alphabet’s stock has been in the last ten years. So, is this a buying opportunity? We have already analyzed Alphabet’s fundamentals, which remain robust under difficult circumstances.

Let us now take a look at Alphabet’s quant factor ratings.

Just last week, Alphabet’s SA Quant rating went from “Hold” to “Strong Buy” as its Valuation factor grade improved from “F” to “D” and Growth factor grade improved from “C” to “C+”. Alphabet’s other factor grades, i.e., Profitability: “A+”, Momentum: “B”, and Revisions: “C”, are holding strong. With an overall quant factor grade score of 4.54/5, Alphabet is rated a “Strong Buy” by SA’s Quant rating system. This rating is now in line with my previous assessment of the stock from May and June of 2022. As you can see below, Wall Street analysts and other SA authors are bullish on the stock too.

In 2022, Alphabet’s stock has tanked by ~30%, going from overbought territory to near-oversold territory on the weekly chart. Recently, Alphabet has been forming a base in the $105-115 zone. After the Q2 report, Alphabet’s stock is bouncing ~5%; however, the stock remains firmly entrenched in its downward wedge pattern. At current levels, Alphabet is trading in a no-trade zone. If the stock can rally past the $120-$135 resistance zone, it could hit new highs over the coming months. On the contrary, if it fails to break past $115-120 in the near-term, Alphabet could easily test a long-term support trendline and 200DMA at ~$90-95 (and a break of this support could send the stock to a pre-COVID high of $75 (unlikely, but possible)).

In recent weeks, trading volume has been trending lower, which could be viewed as a sign of seller exhaustion (amid an ongoing correction). Considering the base formation and price-volume action in Alphabet’s stock, I think it is a good long-term buy here despite a potential downside of 25-30% from current levels. Alphabet’s fundamental and quantitative data support a long position too.

An economic recession is on the horizon, and that could result in a continuation of Alphabet’s ongoing multiple contraction. Honestly, I do not know where the bottom is, and I will not play the guessing game. The eventual bottom will depend on how deep the recession turns out to be, and we will only see it in hindsight. From a long-term perspective, Alphabet looks like a good buy here. However, let’s determine Alphabet’s intrinsic value and expected returns to make an informed investment decision.

As you can see in the image, Alphabet’s fair value is ~$1.56T ($117.69 per share). With the stock trading at ~$110, it is currently trading at a slight discount to its fair value. But what sort of returns could Alphabet deliver from these levels?

Today, Alphabet trades at a P/FCF multiple of ~20x, which is the lowest multiple it has commanded over the last ten years.

Considering Alphabet’s revenue growth (10-15% per year) and margin profile (operating margin 30-35%, FCF margin 25-30%), this multiple is fair. Now, let’s try to figure out the expected return for Alphabet until 2026.

Assuming a P/FCF multiple of ~20x in 2026 (inverse of long-term average interest rates of 5%), Alphabet would generate a price return of 91% from current levels over the next 4.5 years, i.e., a CAGR return of 15.5%.

Alphabet’s expected return exceeds my required IRR of 15%, and hence, it is a buy for me. However, Alphabet investors could do even better. As you may know, Alphabet has lots of cash on its balance sheet ($125B – cash and marketable securities), and it is generating tons more in free cash flows every quarter ($65B – TTM FCF). After years of piling up cash on its balance sheet, Alphabet’s management has finally implemented an aggressive capital return program that includes a $70B buyback authorization. In Q2, Alphabet repurchased shares worth $15B (outpacing FCF of $12.5B).

Considering Alphabet’s cash balances of ~$125B, I expect the company to return all of its future free cash flows back to shareholders over the coming years.

As you can see from the table above, stock buybacks do not increase the value of a business (market cap). However, if an investor holds onto Alphabet’s shares for the next 4.5 years, he/she could generate a CAGR return of 21.4% (instead of 15.5%). This is how Alphabet’s management could boost shareholder returns via financial engineering (capital return program).

Concluding Thoughts
In the face of a potential economic downturn, Alphabet delivered a marginal miss on revenue and earnings during Q2 that could be attributed to the effects of foreign currency fluctuations. In reality, Alphabet’s results were not as bad as feared, and the company seems to be doing well in a bad macroeconomic environment (a fair reflection of its ultra-high-quality businesses and their incredible moats).

While Alphabet is still growing sales at a healthy clip (~13% y/y, ~16% constant currency), its operating income was flat(ish) in Q2 2022, and free cash flows fell to $12.5B. However, a cash hoard (including marketable securities) of ~$125B and little debt (~$14B) affords Alphabet’s management ample room to maneuver. As per Sundar Pichai, Alphabet as a company will work on sharpening its focus; however, the investments in long-term growth will continue (especially in Cloud and AI). With that being said, Alphabet remains a free cash flow producing machine, and there’s nothing to indicate that it won’t be so in the future. An economic downturn could pose near-term challenges for Alphabet; however, its enviable positioning in Search, Ads, & Cloud, combined with a reasonable valuation, makes it a no-brainer buy.

From a long-term investor’s perspective, Alphabet is a great buy right here. In my view, Alphabet is a reasonably-valued, infinite buyback pump. If you are worried about the possibility of another down leg (in the event of a deep economic recession), then I would suggest the use of a 6-12 month DCA plan to accumulate a long position in Alphabet. Seeking Alpha