This post is by no means advice against buying Alphabet stock. I am very uneducated when it comes to Alphabet stock.

Nevertheless, I think many pitches of Alphabet, including this presentation by Whitney Tilson are dismissive of one key valuation issue.

Alphabet is growing its moat every day – Common 2017 platitude

Advertising is cyclical

A key mistake when looking at current and future valuation multiples, is to assume exponential growth without cyclicality in cyclicals. Slide 27 shows future ratios based on extrapolation of growth. Earnings are not normalized. To be clear, cyclicality is absolutely fine for a high moat / return on capital, secular growing business, it should just be discounted in the valuation!

While the large tech stocks are praised to widen their moat every day, we have to remember that Alphabet is not growing in a vacuum, and indeed its clients (i.e. advertisers) are more cyclical.

My argument is simple:

  1. in a recession, non-measurable ROI investments are among the first being cut at companies (e.g. advertising), see the recovery 2009 – 2011 in the below chart of US ad spending (in the 20th century, yearly changes in ad spend have roughly tracked changes in GDP)
  2. Google has been able to grow revenues in the 2009 recession, as it had a long growth runway and superior value proposition
    • initially, the ROI on Google ads for clients was much higher than conventional ads because of drastically better targeting
      • superior relative ROI protects against a recession as clients will cut advertising with inferior ROI first
    • Today, Alphabet grew to a staggering 15% market share of global ad spending (Google and Facebook control a combined >20% today)
      • as Google becomes more dominant
        • it is only strategic for Google to steadily capture more of this extra value of online targeting for itself through higher (quasi-monopolist) pricing, and for the relative ROI gap versus offline to come down accordingly
        • Clients ad budgets are increasingly online, diminishing the ad spending slash cushion that existed in 2009
  3. Google revenue’s sensitivity to a global recession should therefore grow over time as it “becomes” the ad spending market. In other words, in the next recession, Google’s revenue could even shrink.

Using a 10% discount rate, Google’s value decreases 20% if it has a one-off two year setback of flat revenues.

Conclusion

Alphabet is growing its cyclicality every day – TC

While many like to opine that Alphabet is growing its moat every day, I will add that Alphabet is also growing its cyclicality every day by growing their take of corporate costs in the old cyclical world. And that is probably absolutely fine for this business, and its (true) long-term investors. As for short-term oriented investors, hopefully they will exchange their shares at attractive price levels when the cyclicality of this great business rears its head.

global ad revenues.PNG

For Google ad revenues, 2009 is an afterthought

 

Marketing spend US.PNG

For total US ad spending, it took five years (!) to recover from the 2007 peak.