Big technology has taken center stage and things are heating up. Alphabet (NASDAQ:GOOGL) reports second quarter results today. Microsoft (MSFT) joins his GOOGL today, followed by Metaplatform on July 26th, while Amazon (AMZN) and Apple (AAPL) are set to report earnings next week on August 3rd. Big tech companies are driving the market up, and it’s entirely possible that these companies will continue to dominate the business landscape for the next decade, unlike any other time. Technology continues to lead innovation, and many overlook the position of liquidity in big tech. AMZN, AAPL, GOOGL, MSFT and META have a total of $377.24 billion in cash on hand and an additional $159.96 billion in long-term investments on their balance sheets. These companies have over $500 billion in liquidity on hand without accessing the bond market. None of these companies are cash tight and can put as much capital into profit centers and growth projects as they need to maintain their market leadership position. I can’t wait to see what these companies report after looking at the numbers, but the one I’m most interested in is GOOGL. Because we think GOOGL is the most undervalued and could be a big winner this earnings season.
From a valuation perspective, GOOGL looks like a home run
Markets are boiling in 2023, with the S&P 500 up 18.62% and the Nasdaq up 35.10%. META jumped 135.90%, fueled by big tech, followed by AAPL at 53.47%, AMZN at 51.48%, MSFT at 43.49% and GOOGL at 34.67%. With market capitalizations ranging from $754 billion to $3.02 trillion, these companies are performing poorly, but perhaps have more room to run, and GOOGL is likely to see the most interesting valuation reflected in earnings. These companies generated $387.65 billion in operating cash in the last 12 months (TTM) and total free cash flow (FCF) after capital expenditure allocations of $225.8 billion. It’s staggering considering these numbers, and these companies are making profits with their fists clenched.
AMZN is the only company within this peer group to generate negative FCF in TTM through capital expenditures. The average price of AAPL, GOOGL, MSFT and META to his FCF is 35.78x. From a valuation standpoint, I like to see how much I’m paying for FCF. Because FCF is simply cash-in versus cash-out, it is more difficult to distort the profit measure. GOOGL’s FCF is trading at 24.68x, while AAPL is trading at 30.97x, META at 42.93x and MSFT at 44.53x. Essentially, it would take 24.68 years to generate the initial investment in GOOGL’s FCF if it acquired the entire company.
Next, we look at future EPS forecasts for 2023 and 2024 from analyst consensus. The good news is that these companies have broad coverage, so he’s 30-40 analysts providing forecasts, not 3-4. GOOGL’s 2023 projected P/E is 22.48, while his P/E for other peers is 25.68 81.76. Looking forward to 2024, GOOGL’s P/E ratio is 19.14 times, while his peer group’s P/E ratio is 20.81 50.19 times. GOOGL’s EPS is expected to be $5.34 in 2023 and $6.27 in 2024, representing a 17.42% year-over-year growth. There’s no reason why GOOGL can’t grow to a valuation that’s on par with its peer group’s average based on where its peer group trades.
It’s not all about valuation, it’s about finances
Many investors, myself included, focus on valuation methodologies, but it is very important to focus on financial conditions. These are the biggest companies in the world, and I want to know how efficiently they generate profits. Warren Buffett has a 40% gross margin rule and believes companies that can generate 40% or higher gross margins have a competitive advantage over their peers. In his 34-page Kindle edition, Warren Buffett and Interpreting Financial Statements, he writes:
“As a very general rule (although there are exceptions), companies with gross margins above 40% tend to be companies with some kind of permanent competitive advantage.
AMZN generates the most revenue, but the lowest profit margin. GOOGL generated $284.61 billion in revenue, generating his third-largest gross margin of 55.30%. This determines profitability.
GOOGL generated net income of $58.59 billion in TTM, $61.91 billion in FCF and $87.5 billion in EBITDA from revenue of $284.61 billion. GOOGL has an operating margin of 20.58%, an FCF margin of 21.75% and an EBITDA margin of 30.74%. GOOGL’s profitability levels are not on par with MSFT’s, but operating at a bottom margin of 20.58% is staggering for any business, especially one that generates $284.61 billion in revenue. When calculating the profitability of each company by its current market capitalization, GOOGL trades at the lowest valuation in each category. MSFT has the highest profit margin, but you will pay 37.03 times MSFT’s net profit at its current market cap. This compares to 26.08 times GOOGL’s net profit at its current market cap. GOOGL is trading at one of the most attractive valuations, whether you look at the 2023 and 2024 earnings P/E ratio, EBITDA, net income, or FCF.
What to expect at the Q2 earnings call
There are a few things that I would like to see in the second quarter earnings. Google Cloud is very important to me. There is speculation that search revenue will be cannibalized by Chat GPT, Google Bard, and other AI programs. We don’t know yet, but that doesn’t mean GOOGL shouldn’t diversify its profit centers. Google services have long been the company’s sole profit center, and Q1 2023 was the first quarter in which Google Cloud generated positive operating profit. On a year-over-year basis in the first quarter, Google Cloud revenue increased 28.05% to $7.45 billion and operating profit increased $897 million. I would love to see Google Cloud start closing the gap between AWS and Azure. If GOOGL continues to grow this line of business and every quarter he can generate over $1 billion in operating income, the market should respond very well to these metrics.
GOOGL’s board of directors had approved an additional $70 billion to be allocated for share repurchases on April 19, 2023. At the end of the first quarter, GOOGL had $115.10 in cash on hand, with an additional $31.21 billion in long-term investments. Total liquidity position was $146.32 billion and total debt was $29.49 billion. GOOGL has a cash-to-debt ratio of 496.1%, and if it were to eliminate all debt tomorrow, it would have $116.82 billion in liquidity. I expect a significant amount of share buybacks to occur in the quarter. Doing so will give confidence to the investment community that executives feel the stock is undervalued.
We would also like to know the progress of GOOGL’s AI efforts and how GOOGL plans to use AI to help partners who rely on GOOGL for advertising. GOOGL promised to develop state-of-the-art large-scale language models, improve its products for end-use benefits, and provide tools to enable organizations to benefit from AI. If AI is the next evolution in computing, GOOGL will have to face off against MSFT and AAPL, but for now MSFT seems to have a big lead in the competition.
Of the 5 companies I have used in my peer group, I am a shareholder in AAPL, AMZN, GOOGL and META. I wish I had bought MSFT a while ago as well, but I can’t own everything. Thankfully, I have significant exposure to MSFT in his ETFs and mutual funds. I believe all five of his companies will provide shareholders with improved capital value in the future, but based on their lower valuations, he feels GOOGL is the best buyer at this time. At today’s prices I think you are getting great value. If GOOGL hits solid numbers, it could be the biggest winner in this quarter’s results.
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