TIP847: Alphabet (GOOGL): The Megacap That Still Might Be Underrated w/ Kyle Grieve & Shawn O’Malley

Alphabet is currently the second largest position in the intrinsic value portfolio, with a weighting of approximately 14%. Over the past 18 months, the company has experienced significant changes in stock price and business strategies. Alphabet consists of various high-performing businesses, including YouTube, which generates around $36 billion annually, a stark contrast to its acquisition cost of $1.6 billion.

The market has historically undervalued Alphabet, primarily focusing on its search business amid concerns about competition from AI-driven search engines like ChatGPT. Despite fears of users abandoning Google search, the company continues to provide reliable factual answers, maintaining its competitive edge. Kyle Grieve noted that Alphabet's value has nearly doubled since its inclusion in the portfolio, and its current pricing is reasonable compared to other tech giants.

Alphabet is expected to invest about $200 billion in data centers this year, although Grieve typically prefers smaller-cap stocks. Concerns linger regarding AI's potential impact on Alphabet's profitability, as investments in AI could reduce structural profitability. The stock was trading at around 17 times earnings, down from 30 times a year prior, indicating a pessimistic market sentiment despite a doubling in stock price since then.

The company faces ongoing regulatory scrutiny and is often labeled a monopoly, yet legal outcomes have generally favored big tech firms. Alphabet pays Apple approximately $20 billion annually to remain the default search engine on Apple devices, and its shares surged over 50% following a favorable court ruling regarding its Chrome browser. Google’s search revenue has grown at a 14% compounded annual growth rate over the last two years, driven by AI integration into its monetization strategy.

The cloud division has also shown promising growth, achieving positive operating income with cloud revenue reaching $58 billion last year and a 24% operating profit margin. Kyle Grieve and Shawn O'Malley discussed Google Cloud's impressive revenue growth, compounding at 40% annually over the past decade. O'Malley highlighted that Google Cloud's operating income growth is expected to outpace revenue growth as margins expand, with recent growth rates hitting 63% and 82% year over year.

Google Cloud's annualized second quarter revenue run rate is now in the $100 billion range, with profitability ahead of schedule and margins nearing 36%. The cloud backlog has grown significantly, from $106 billion in Q2 of last year to five times that amount, although Grieve cautioned about revenue recognition issues tied to a significant portion of this backlog being linked to a single customer, Anthropic.

Alphabet's investments in AI and data centers are substantial, with commitments of up to $40 billion into Anthropic. However, the company's return on invested capital is trending downward, now at its second lowest since going public. The episode concluded with discussions on the challenges Alphabet faces in justifying its large investments in data centers, which require generating between $70 billion and $100 billion in new sales annually.

Financially, Alphabet has raised approximately $85 billion in equity this year, with long-term debt surging to $98 billion, reflecting a ninefold increase since the end of fiscal 2024. The company also has over $800 billion in off-balance sheet liabilities due in the coming years, indicating a complex financial landscape. Despite robust demand for its bonds, with over $100 billion in orders for a recent issuance, Alphabet's cash position of $242 billion may diminish quickly due to its current spending rate.

The business environment for Alphabet is perceived as riskier than in the past, with uncertainty surrounding the profitability of its AI investments. Operating margins are currently in the low 30s, with future depreciation from capital expenditures expected to compress these margins. Analysts remain optimistic, issuing strong buy recommendations with an average target price of around $430, compared to its current price of about $340. However, O'Malley expressed caution, suggesting that Alphabet is closer to fair valuation now than a year ago, advocating for a wait-and-see approach.

The share count has been declining since 2018 due to buybacks, but increased share issuance could pressure the stock in the short term. The durability of recent price increases remains uncertain, with concerns about potential commodification in the market.