Though one can debate some of the valuation figures that were shared, Deutsche Bank's latest estimates for Google's cloud operations provide more grist for the argument that valuing Alphabet (GOOGL) solely based on its near-term earnings serves to undervalue the company.
In a pair of research notes released on Thursday, Deutsche analysts Karl Keistead and Lloyd Walmsley argued that Alphabet's Google Cloud unit, which covers both the Google Cloud Platform (GCP) and the G Suite productivity app business, is worth around $225 billion, or nearly $325 per share. They also used this upbeat view of Google Cloud's value to hike their 12-month target for Alphabet's shares, which currently trade around $1,190, by $125 to $1,600.
Keirstead and Walmsley's valuation estimate for Google Cloud stems from valuing GCP at 15 times a 2022 revenue estimate of $16.6 billion, and from valuing G Suite at 5 times a 2022 revenue estimate of $5.3 billion. An 11% discount rate is applied to the GCP estimate, and (with Deutsche citing lower execution risk) a 9% discount rate is applied to the G Suite estimate.
Even for a business growing as fast as GCP -- Deutsche sees its revenue growing 76% this year to $4.7 billion, and respectively growing 68%, 50% and 40% over the next three years -- a valuation of 15 times expected 2022 revenue feels rich. Particularly given that GCP can't be given a valuation premium on account of a leadership position -- excluding China, where Alibaba and Tencent are the biggest players, GCP is the #3 player in the public cloud infrastructure (IaaS) and developer platform (PaaS) services market, trailing Amazon.com's (AMZN) Amazon Web Services (AWS) and Microsoft's (MSFT) Azure. Deutsche sees AWS and Azure's IaaS/PaaS revenue respectively coming in at $34 billion and $11.9 billion in 2019.
With all that said, even a GCP valuation of, say, 10 times expected 2022 revenue subject to an 11% discount rate would (together with a G Suite valuation similar to Deutsche's) make Google Cloud a very valuable asset. Whether or not GCP delivers over $16 billion in 2022 revenue, the platform's technology strengths in areas such as AI/machine learning service, big data/analytics offerings and support for open-source software platforms work in its favor as the IaaS/PaaS market continues growing strongly. And so might new Google Cloud chief Thomas Kurian's efforts to overhaul Google's enterprise sales and support efforts (a historical weak spot) with the help of aggressive hiring.
Importantly, though Deutsche assigns Google Cloud a value equal to more than a quarter of Alphabet's current market cap, the firm forecasts the segment will be a slight drag on Google's bottom line this year. It sees G Suite generating earnings before interest and taxes (EBIT) of $389 million, but also expects GCP to record EBIT of negative $703 million.
Deutsche does see GCP turning profitable in the coming years, and forecasts the whole of Google Cloud will generate EBIT of $4.2 billion in 2022. But either way, assuming Deutsche's 2019 estimates for Google Cloud's profitability are close to the mark, valuing Alphabet solely based on expected 2019 EPS of $51.16 (excluding the impact of an EU fine), or based on expected free cash flow (FCF) of $31.2 billion, would serve to grant negative value to a pretty valuable business segment.
And though Deutsche does see Google Cloud generating $525 million in EBIT next year, such a figure would equal just a little over 1% of Alphabet's 2020 pre-tax income, based on current analyst estimates. As a result, valuing Alphabet based on its 2020 EPS consensus estimate of $55.45, or FCF consensus estimate of $39.3 billion, would still serve to undervalue Google Cloud.
GCP is by no means the only valuable Alphabet business that appears to be a near-term drag on EPS and FCF. The Waymo self-driving unit, which appears to have produced a large portion of the $3.9 billion in operating losses recorded by Alphabet's Other Bets segment over the last four quarters, is a good case in point. While estimating just how much Waymo is worth right now is very much a guessing game -- Morgan Stanley recently cut its Waymo valuation by $70 billion to a "mere" $105 billion -- it's safe to say that the autonomous driving hardware, software and mapping progress it has produced over the last decade make it a pretty valuable asset.
Google Maps, which Google is just beginning to meaningfully monetize, might be another valuable asset that for now is either losing money or is just modestly profitable. In August, Morgan Stanley forecast Maps' revenue would grow 64% next year to $4.86 billion, and total more than $11 billion in 2023.
And while there's a good chance that YouTube -- Google's second-biggest revenue growth driver in recent years after mobile search -- is now profitable, this hasn't been a business that Google has run with near-term profitability in mind. As a result, valuing Alphabet based on near-term EPS and FCF might also serve to undervalue YouTube, whose annual revenue has been estimated to be north of $15 billion.
Currently, Alphabet sports an enterprise value (market cap minus net cash) of about $707 billion, or 18 times next year's consensus FCF estimate. Given that Alphabet is still seeing high-teens revenue growth and solid double-digit profit growth, it's not hard to make a case that this by itself is a reasonable valuation for a tech giant whose biggest platforms generally look as strong as ever.
However, once you assign fair valuation estimates to valuable Alphabet businesses that for now appear to be either losing money or producing modest profits, Alphabet's valuation arguably goes from looking "reasonable" to pretty cheap.
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