Alphabet, with its dominant Google search engine, Android operating system and YouTube platform, is an impressive business1
It has generated a gross margin in excess of 55% and an EBITDA (earnings before interest, taxes, depreciation, and amortisation) margin above 30% over the past five years. Capital intensity (expenditure to sales) as a percentage over that period was in the low teens, enabling a prodigious 20% free cashflow (FCF) margin and an attractive forward FCF yield of 6.5%2.
We look for companies that can sustainably drive high levels of FCF, but we also want them to be good stewards of this cash. So the question becomes what should Alphabet do with it? There are four options: invest in the business, acquisitions, return cash to shareholders, or let it run up on the balance sheet. Intelligent capital allocation requires the appropriate balance between these available uses of capital. So how is Alphabet acting?
The core businesses are strongly positioned and well invested, in our view. Indeed, R&D has increased from $6 billion in 2012 to $38 billion in 2022, with the R&D intensity increasing 30bps over the period to 13.4% of sales, and the employee count climbing from 53,861 in 2012 to 186,779 at end Q322. Similarly, capital expenditure has climbed from $3.3 billion in 2012 to $24.6 billion in 2021 with capital intensity rising 250bps to 9.6%. The company has not shown leverage on investment expenditure despite increasing the top line more than 5x over the past decade3. Clearly there is space to improve while still investing in key growth areas such as AI, search and cloud. The shutdown of its Stadia gaming service4 looks like an important step and suggests investment intensity won’t be increasing. The recent announcement of 12,000 jobs being cut5 – around 6% of the workforce – is another sign of change in a company that has historically not worried about expenses.
Acquisitions of any material scale are unlikely in our view, given the regulatory shift towards “big tech”. So, this just leaves capital return or letting the cash build up. Over the past five years Alphabet has increased net share repurchases tenfold from $5 billion in 2017 to $50 billion in 2021, but despite this net cash has grown by almost $30 billion to stand at $111 billion, around 8% of market cap6. So Alphabet is moving in the right direction, but it needs to go further – and we think the introduction of a material dividend would show genuine commitment to regular capital return. We note the annual report no longer explicitly states that it does not expect to pay a dividend.
Figure 1: Share count evolution of Alphabet, Apple and Microsoft
Source: Bloomberg, December 2022. Diluted weighted average shares. Apple is on LHS axis, Alphabet and Microsoft RHS.
While some might see a dividend as an admission the company is no longer in the growth camp, given the 6.5% FCF yield we think the market is already there. There are benefits of embracing maturity – not least a potential new investor base – and it wouldn’t be the first tech firm to go that route. Apple started a dividend in 2012 and has reduced its share count by almost 40% since then, returning a staggering $675 billion to shareholders which is the equivalent if around 95% of FCF generated over the period. Microsoft started a dividend in 2003 and over the past decade has reduced its share count by around 12%, returning around $290 billion to shareholders (circa 75% of FCF)7.
Dividends may be seen as boring, but the debate they prompt around future investment plans is important. We believe the discipline of regular capital return, via dividends and share repurchases, is underappreciated as it helps promote a focus on superior capital allocation. We see some encouraging signs from Alphabet that it is an improving capital allocation story, a dividend is the next step on the journey in our view.
We believe it can offer this while still investing heavily to be the leader in AI, search and cloud. We think this shift would be greatly welcomed by investors.
