Stock of the week - Alphabet (01.02.2024)

• Alphabet reported Q4 2023 earnings on Tuesday
• Results turned out to be mostly better-than-expected
• Lack of clear guidance on AI-impact seen as disappointment
• Stock dropped 7% on Wednesday as hawkish FOMC meeting added to pressure
• A look at the valuation
• Stock trades 9% below recent all-time highs

Alphabet (GOOGL.US) reported its fourth quarter earnings report on Tuesday after market close. Release triggered a 5% drop in the after-hours trading, which was later deepened to 7% during Wednesday's cash session on the back of a hawkish FOMC meeting. However, were the company's earnings that bad to justify the drop? Or was it because the bar of expectations prior to the release was set so high? Let's take a look at it!

Q4 2023 earnings report

• Revenue: $86.31 billion vs $85.36 billion expected (+13.5% YoY)
  • Google Services revenue: $76.31 billion vs $75.97 billion (+12.5% YoY)
    • Google advertising: $65.52 billion vs $65.8 billion (+11% YoY)
      • Google Search & Other: $48.02 vs $48.18 expected
      • YouTube ads: $9.20 billion vs $9.16 billion
      • Google Network: $8.30 billion vs $8.55 billion
    • Google Subscriptions: $10.79 billion vs $10.15 billion (+22.7% YoY)
  • Google Cloud revenue: $9.19 billion vs $8.95 billion (+25.7% YoY)
  • Other Bets revenue: $657 million vs $299 million expected (+190.7% YoY)
  • Hedging: $150 million vs $37.1 million expected
• Revenue excluding Traffic Acquisition Costs: $72.32 billion vs $70.97 billion expected (+14.6% YoY)
• Operating income: $23.70 billion vs $23.82 billion expected (+30.5% YoY)
  • Google Services: $26.73 billion vs $25.75 billion expected (+26.7% YoY)
  • Google Cloud: $864 million vs $427 million expected (+280% YoY)
  • Other Bets: -$863 million vs -$1.26 billion expected (-$1.63 billion a year ago)
  • Hedging: -$3.03 billion vs -$1.36 billion expected
• Operating margin: 27.5% vs 27.7% expected (23.9% a year ago)
• Net Income: $20.69 billion vs $20.25 billion expected (+51.8% YoY)
• EPS: $1.64 vs $1.59 expected ($1.05 a year ago)
• Capital Expenditures: $11.02 billion vs $9.82 billion expected (+45% YoY)

Financial dashboard for Alphabet. Source: Bloomberg Finance LP, XTB Research

AI-hype fading?

As one can see in the previous paragraph, Alphabet's earnings for Q4 2023 were not bad at all. Company missed expectations in some metrics, but, overall, the report was solid. Having said that, one may wonder what was driving the post-earnings sell-off on the stock. The answer is simple - the same thing that was driving Alphabet's share price gains throughout 2023. 

Artificial Intelligence is a new craze among tech shares and its potential to be the next game changer for the sector has been fuelling the rally in shares of companies like Alphabet, AMD or Microsoft last year. However, expectations need to be confirmed by actual results or at least by a somewhat concrete guidance to be kept alive, and investors hoped that the time for it has come already. Unfortunately, it was not the case. Alphabet said that Artificial Intelligence is improving its search and cloud computing services, but AI-related statements were far from specific. This means that the impact of AI on Alphabet's business, while most likely positive, is still vague and hard to quantify, and this creates a risk of current valuations being too rich. 

Summing up, post-earnings pullback in Alphabet's shares was most likely driven by AI disappointment. However, it should be said that this disappointment did not result from outlook deterioration, but from the fact that uncertainty of an exact AI impact on actual results is still very high.

A look at valuation

Let's take a quick look at Alphabet's valuation using two often used methods - Discounted Cash Flows (DCF) and multiples. As Alphabet is not a dividend paying stock, it cannot be valued with a third method we often employ in our Stock of the Week analysis, the Gordon Growth Model. We want to stress that those valuations are for presentation purposes only and should not be viewed as recommendations or target prices.

Discounted Cash Flow method

Let's start with probably the most popular fundamental model for valuing stocks - Discounted Cash Flow method (DCF). This model relies on a number of assumptions. We have decided to take a simplified approach and base those assumptions on averages for the past 5-years. Detailed forecasts for 10 years were made with terminal value assumptions being set as follows - 4% terminal revenue growth and 9.25% terminal weighted cost of capital (WACC). Such a set of assumptions provides us with the intrinsic value of Alphabet's shares of $239.71 per share - over 70% above current market price!

A point to note is that the intrinsic value obtained via the DCF method is highly sensitive to assumptions made. Two sensitivity matrices are provided below - one for different sets of Operating Margin and Revenue Growth assumptions and the other for different sets of Terminal WACC and Terminal Revenue Growth assumptions.

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

Multiples

Next, let's take a look at how Alphabet's valuation compares with peers. We have constructed a peer group consisting of Meta Platforms, Microsoft, Baidu, Snap and Pinterest, and we have taken a look at 6 different valuation multiples - P/E, P/BV, P/S, P/FCF, EV/Sales and EV/EBITDA.

Taking a look at the table below we can see that there is a lot of volatility in multiples for Alphabet peers, especially in the case of P/E multiple. We have decided to use median multiples for valuation as means are significantly distorted by outliers. Using median multiples provides us with valuation ranging from $140.75 in case of EV/sales multiple to $240.82 in case of P/FCF multiple. A trimmed mean (excluding the highest and lowest valuations) provides us with an intrinsic value of $189.07 per share, or around 35% above yesterday's closing price.

Source: Bloomberg Finance LP, XTB Research

A look at the chart

Last but not least, let's take a look at the Alphabet chart (GOOGL.US). Taking a look at the chart at D1 interval, we can see that the stock has reached fresh all-time highs recently but has slumped from record highs following release of Q4 2023 earnings. Stock finished yesterday's trading around 9% below all-time highs. Bears attempted to break below the $141 support zone but were unable to do so yesterday. Nevertheless, even a break below this hurdle would not make the outlook bearish. The lower limit of the Overbalance structure, that guards the uptrend, can be found in the $134.15 area, or around 4.3% below yesterday's close. A break below this hurdle would signal trend reversal, but until that happens, the pullback should be seen as a correction.

Source: xStation5