Alphabet (GOOG/GOOGL) reported excellent 4Q20 results across the board in all segments and on all financial metrics.  Revenue, EPS, Operating income and profit margins each easily and materially beat Wall Street estimates.  These factors alone are worth a nice boost in GOOG/GOOGL shares.  However, the company also took another meaningful step to improve financial disclosure by breaking out revenues and operating profits for its fast-growing cloud business unit.  Google has long been criticized for its lack of disclosure, so while this additional information was promised this quarter, the underlying detail it revealed also helps the shares. This is exactly the type of earnings report Northlake hopes to see.  Better than expected results that lead to rising estimates and support expanded valuation metrics.  Simply put, Alphabet’s results are a catalyst in the short-term and support a more bullish multiyear thesis.

Google’s core advertising businesses including search and YouTube reported the best growth in almost two years.  Search bounced back to 17% growth from just 6% growth last quarter as advertisers appear to have returned despite the ongoing pandemic.  YouTube was particularly strong with revenue growth of 46%.  YouTube is reliant on brand advertisers that cut back sharply during COVID even as direct response advertising from e-commerce companies increased.  One concern for Google was that it was losing share to Amazon for product searches.  The fourth quarter results strongly suggest this is not the case.  Besides the return of brand and retail advertisers, Google also saw strength in technology and entertainment verticals.  This is very encouraging given that Google has large exposure to service industries in travel and hospitality, around 10% of advertising revenue, and these areas are poised to recover later this year and through 2022.

The widely anticipated results from Google Cloud revealed mixed news.  Revenue growth was fantastic at 48%, up a little from the growth last quarter and better than Amazon AWS.  However, the operating margin came it at -32% versus expectations as high as breakeven.  Clearly, Google is investing heavily for what it sees as a big opportunity in cloud services.  The company is way behind the top two players, Amazon AWS and Microsoft Azure, and the cost of catching up might be higher than Wall Street expects.  In 2015/16 AWS was about as large as Google Cloud is presently.  Back then AWS had a positive 25% operating profit margin.  Alternatively, Google Cloud spent 60% as much in operating expenses in 4Q20 and produced just 1/3^rd the revenue of AWS.  Fortunately, investors do not mind, and maybe even prefer, heavy investments ahead of big new addressable markets.  Google Cloud should see profit margins hockey stick higher at some point but management cautioned that heavy spending would continue in 2021.

One positive of the larger losses at Google Cloud is that is that it implies that the margins at core Google search and YouTube are higher than expected both presently and historically.  Google profit margins have been a point of contention over the years.  The company spends aggressively to pursue growth.  Learning that core margins have been better than it appeared helps build confidence in the financial model and management’s discipline on expenses.

Overall, the quarter is a big win for Alphabet investors.  The results and added disclosure provide a near-term catalyst for the shares, which rose about 7% in immediate response.  For long-term investors like Northlake, the news is even better as the added disclosure and great results support elevated long-term growth expectations.

We have updated our valuation analysis for GOOG/GOOGL.  We have increased estimates of EBITDA, our primary valuation metric, based on the better revenue growth and margins in the 4Q20.  Management comments suggest growth is sustainable, especially given a coming boost from advertisers in leisure, travel, and hospitality.  We also slightly raised the multiple given the improved disclosure and transparency and the rapid growth at YouTube and Cloud.  Competitors in these businesses receive very high valuations.  Finally, we continue to add hidden value for Alphabet’s leadership in automated vehicles via Waymo along with other investments the company has in its Other Bets. 

At 15X 2021 EBITDA plus 60% of 2021 projected free cash flow and $80 billion in hidden value, we believe the shares have upside to $2,300, 12% higher than current prices.  Even higher targets can be calculated on a sum of the parts of the basis.  This approach is gaining more adherents now that adequate disclosure about the company’s business units have finally arrived.  Northlake clients will continue to hold GOOG/GOOGL and we will use any weakness to add to positions for newer clients.

GOOG/GOOGL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.