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1 Big Reason I Own Alphabet

By Andrés Cardenal - Feb 9, 2016 at 8:20AM

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Alphabet offers both impressive profitability in online advertising and amazing potential for growth in other bets.

IMAGE SOURCE: ALPHABET.

Alphabet (GOOG -0.27%) (GOOGL -0.21%) is one of my favorite companies in the market right now, and it's also the biggest position in my personal portfolio. I believe Alphabet offers a pretty exceptional opportunity for investors, as the business provides both rock-solid fundamentals from its Google online advertising business and tremendous potential for disruptive innovation from other bets.

A tale of two segments
In August, the company formerly known as Google changed its name and corporate structure to better reflect its current business model. Alphabet is now a collection of businesses of which online advertising powerhouse Google is the largest and most important contributor in terms of sales and earnings. The "other bets" segment includes several different projects and businesses such as Fiber, Nest, self-driving cars, Google X, and highly innovative health-care initiatives such as Calico and Verily.

Google is the global market leader in online advertising. The company owns seven different properties with over 1 billion monthly users each: Search, Android, Maps, Chrome, YouTube, Google Play, and Gmail. Google is one of the most valuable brands in the world, and the company capitalizes on the massive amounts of data it collects from its users to provide better services and more efficient advertising. The bigger Google becomes, the more valuable the service is to both users and advertisers, and the company has already reached gargantuan scale. 

Facebook (META -0.76%) is making big inroads in online advertising, especially when it comes to mobile, a crucial growth segment in the industry. Facebook ended the fourth quarter of 2015 with 1.59 billion monthly users, and nearly 1.44 billion users access the platform via mobile devices on a monthly basis. Based on data for the fourth quarter of 2015, Facebook makes nearly 80% of advertising revenue from mobile, a big increase versus 69% of advertising revenue that came from the mobile segment in the fourth quarter of 2014.

It makes sense to expect Facebook and other social-media players with a smaller revenue base to outgrow Google over the coming years, as a smaller size generally means superior potential for growth. However, Google is still the undisputed leader in online advertising, and the industry should offer plenty of room for multiple different players to continue thriving over the years ahead.

What the numbers are saying
When you look at Alphabet as a whole, the company is reporting remarkably healthy financial performance. Total revenue grew 18% in U.S. dollars and 24% in constant currency during the fourth quarter of 2015, reaching $21.3 billion over the period. The business is widely profitable, too. Alphabet generates big operating margins in the neighborhood of 25% of revenue. 

Even better, the Google division produced $74.54 billion in sales during the full year 2015, while operating income in this segment was $23.42 billion. This means that Google produced an amazing operating profit margin of over 31% of sales during the year 2015, so Alphabet's online advertising operations are extraordinarily profitable.

Sales from other bets amounted to just $448 million during 2015, a 37% increase from $327 million in 2014. However, it's important to note that the "other bets" division produced a big $3.57 billion operating loss during the year. That's more than 10 times the revenues this division produced over the period. Alphabet is investing tons of money in other bets, and this is really dragging on the overall financial performance for the time being.

This stark difference when it comes to Google and other bets is a major positive for investors in Alphabet. In the worst-case scenario, assuming that none of the "other bets" businesses prove to be viable in the future, Alphabet could easily give up on these projects and continue generating huge profitability from Google. On the other hand, some of these businesses could deliver explosive opportunities in the years ahead, even if it's hard to evaluate their commercial viability at this stage. 

The good news is that Alphabet doesn't need any external financing to keep its other bets projects running, as the company relies on the massive cash flows Google produces to invest in these areas for the long term. Few companies in the world enjoy the ability to have such a strong focus on long-term potential without thinking about financial viability in the short or even middle term.

Investment decisions are seldom easy. Companies with big profitability and a proven business model typically offer subpar potential for growth. On the other hand, companies with explosive potential for growth and innovation usually carry above-average financial risk, as their earnings and cash flows are hard to predict. When it comes to Alphabet, you get rock-solid consistency from Google and amazing potential for innovation with other bets, and that's a major plus for investors in the company.

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Stocks Mentioned

Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$2,174.75 (-0.21%) $-4.51
Alphabet Inc. Stock Quote
Alphabet Inc.
GOOG
$2,181.62 (-0.27%) $-5.83
Meta Platforms, Inc. Stock Quote
Meta Platforms, Inc.
META
$160.03 (-0.76%) $-1.22

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