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Zero interest rates and the case for google

Charlie Aitken believes it’s clear we’re in a race to zero interest rates globally and that stocks like Google are attractive in this environment.

The other day we saw the Reserve Bank of New Zealand cut interest rates by a surprise 5o basis points to 1%. The NZ dollar fell 2.5% instantly and dragged down the Australian Dollar to a 10-year low of around US67 cents.

It is blatantly clear we are in a race to ZIRP (zero interest rate policy) globally. A trade war between the USA and China has now moved to a global currency devaluation war, led by central banks. Just remember, central banks have limitless firepower and unconventional tools to deploy.

This week we also saw the People’s Bank of China (PBOC) allow the Yuan to trade through 7.00 to the US dollar. This move was a direct response to a threat of further tariffs from the US side. This Yuan move rattled global equity markets as it was seen as an escalation of the trade war and the weaponisation of the Yuan as such.

Bond markets have also reacted to these developments, with the US 10-year bond yield dropping to 1.68%. The value of government bond yields with a negative yield also moved to a record.

These are truly unprecedented times for investors. We are in the midst of an extended trade war between the world’s two largest economies, we are in a central bank race to zero, and associated currency devaluation race. And if the bond market is right, we can expect another 10 years of low growth, low inflation and ultra-low interest rates. The developed world is becoming Japan.


Savers stuck in a hard place

Unfortunately, the biggest losers in all this are savers. Anyone who physically saved their cash by depositing in the bank is being punished for a crime they never committed. Savers in Australia potentially need to get themselves prepared to receive 0% interest on deposits over the next few years. For certain, savers need to assume they will receive negative real interest rates from the bank.

Self-managed superannuation fund trustees need to understand the return on cash will be negative in real terms potentially for the next decade. Central banks will continue to reduce the return on cash.

While many people will say “I’d rather get no return than a negative return”, when looking at other risk asset classes, I remain of the view that equities as an asset class look more attractive than anything else in this environment.

Sure, there will be volatility in equities as short-term traders trade every twitter headline, but outside of the short-term noise the combination of potential capital growth and dividend yield from equities compensates you for the volatility and risk of the asset class. Quite simply, if we are in for another decade of ultra-low interest rates then I see equities beating everything else, albeit with higher short-term volatility.


Look for ‘structural growth’ opportunities

In a low growth, low inflation, ultra-low interest rate world, my view is you want to be invested in ‘structural growth’ stocks. These are stocks who are growing their revenue and profits irrespective of economic conditions. They are usually the leader in their industry and possess the ability to take market share and raise prices. They usually have a fortress balance sheet and are buying back their shares. In May I wrote to you about Microsoft (MSFT:NAS), which in my view is the world’s leading structural growth stock, with less economic cyclicality in its business due to the global digitisation thematic.

On the other side of the equation, this macro scenario is difficult for banks and basic cyclical price taking companies. I currently own no banks globally, no resource stocks, and no cyclical price taking stocks, yet my fund still finds world leading structural growth stocks trading on attractive medium-term valuations. These stocks are generally listed in the USA and we have used the pullback in August to add to them.

What I have done is take the quality and duration of my portfolio to the best we can find. I only want to own the best businesses in the world. The businesses the world simply can’t open for business on a daily basis. One of those businesses is Alphabet (GOOG:NAS), the parent company of Google.

Today I thought you may find it interesting to know a little more detail about GOOG after it delivered strong earnings growth in the last quarter. This is a company that has all the attributes that should drive solid total returns over the medium-term, albeit as a large index weight in the S&P500 and Nasdaq it is subject to short-term volatility driven by broader equity sentiment and headlines around regulation.


More about Alphabet

Alphabet reported much better-than-expected revenue growth in 2Q19, driven by a substantial re-acceleration of Google revenues from 1Q19. (As reported: +19.3% in 2Q19 vs +16.7% in 1Q19; in constant currency: +22.3% in 2Q19 vs +19.0% in 1Q19). Driving this stronger top-line momentum was a sharp reversal of the cost per click/paid click volume trend from 1Q19.

Better-than-expected cost control drove a solid bottom line beat, whilst lower Capex also saw free cash flow surprise to the upside. All the above, combined with improved disclosure on Google Cloud (an $8bn annual revenue run-rate) and the announcement of a further US$25bn share repurchase authorisation, saw the stock rally +10.5% on the day of the results.

Alphabet (GOOG:NAS) one-year price performance

Source: nabtrade

It is still trading below the peak of ~US$1296 set in April this year. From a valuation standpoint, we see the fair value of the business around US$1,191, with a one-year price target of US$1,275. this has been the least crowded of the large US internet plays after the terrible 1Q19 result.


What happened?

After the substantial (and still largely unexplained) slowdown in paid click volumes growth in 1Q19, 2Q19 saw a return to the normal trajectory (strong paid click growth offset by price deflation). It’s worth taking a slightly bigger picture view and seeing just how much of a shock the 1Q19 result actually was: the inflection in both lines below give a sense of how sharply the trend reversed after 4Q18.

Given the relative lack of disclosure on the revenue line, it’s difficult to say with 100% certainty that 1Q19 was a once-off occurrence, though management sounded sanguine about the prospects of recurrence of such when quizzed on the call.

Strong growth in Other revenues were driven by Cloud (effectively sized at being roughly US$2bn of revenue in the quarter), Play Store revenues and the launch of the mid-tier Pixel smartphones.

Combined with lower Traffic Acquisition Costs (the amount Google pays to partners such as Apple to ensure it is the default search engine in iOS), the company saw gross margins come in at 55.6% - modestly above expectations, but still down ~190 basis points year-on-year given:

  1. the ongoing shift to lower margin mobile ads as, and
  2. depreciation and amortisation allocated to cost of services increasing as a result of heavy datacentre investment in FY18.

Operational expenditure growth was 17%, leading to operating profits growing by 13% year-on-year prior to accounting of the European Commission fines in 2Q18.

Trailing 12-month growth in Traffic Acquisition Cost (TAC) has moderated substantially after peaking at ~32% in March 2018, which has seen TAC as a percentage of advertising revenue also trend lower.

Given the focus on cost growth, it is also worth noting by how much gross margins have trended down over the last three years: in part because of the substantial spike in TAC, but also due to the abovementioned mix shift to mobile (which monetises at lower rates) and non-TAC cost of services growing well ahead of revenue (largely due to increased depreciation and content cost growth).

The bottom-line in 2Q19 and 2Q18 was flattered by once-off revaluations of investments to fair market value. Leaving these in (i.e. assuming these revaluations will be a feature of future results) and removing the abovementioned fines means that diluted adjusted EPS grew by 20.9% - this is the diluted non-GAAP EPS number reported by management.

Cash from operations grew by ~25%, and cash conversion remained strong (CFO/NI of 126%). The relatively modest YoY growth in Capex of 11.8% saw free cash flow to the firm grow by 67%. Given the high dollar amount of investment spending, free cash conversion remains under pressure (~37%). Management stated that the growth in year-on-year capex spend for FY19 should moderate substantially vs. the FY18 growth rate of +91%. This means that free cash flow conversion should improve as the year goes along.

From a balance sheet perspective, the company has a total of US$4.1bn in outstanding debt. Given the cash position of US$121bn, there are absolutely no near-term concerns from credit perspective.


What happens next?

Alphabet’s chief financial officer Ruth Porat guided to a more modest pace of operational and capital expenditure growth in 2019 back in January; at the halfway mark, this has proved to be true. In addition, the company has mostly cycled the renegotiation of its Traffic Acquisition Costs meaning the rate of growth in this item (which compresses gross profits) should moderate after spiking over the last few years.

Fundamentally, however, the company will need to become more disciplined on costs or bring some of the bigger ‘Other Bets’ into the light of day, with better disclosure and a path to medium-term profitability. Waymo (self-driving cars) and Verily (the life sciences division) are the two most frequently cited divisions close to monetisation, but no actual data on the profitability is available.

Key near term risks include further regulation (particularly in the US), slowing top-line growth as Amazon becomes more aggressive in competing for online advertising spend (we assess as a medium-to-low risk: Amazon can solve product queries, but is not able to address advertising for services outside of its core offering as yet), defections to rival app stores in the face of lower commission rates, and continued margin compression as cost growth outpaces revenue growth.

On the flipside, key catalysts would be better disclosure among some of the more mature ‘Other Bets’, better disclosure on the Google Cloud business (any data on profitability would help to understand where it is in its’ lifecycle) and the finalisation of some of the regulatory investigations with reasonably benign outcomes. This latter is unlikely to occur soon, and the regulatory risk may be an overhang on the stock for some time to come.

Finally, it is worth reiterating that management substantially expanded their share buyback authorisation to US$25bn. I don’t think the Board would have agreed to such a large increase unless they had visibility on Capex intensity in future moderating and confidence in the ability of the business to generate sufficient cash flows to fund such a programme. As such, it likely means there is somewhat of a floor to the stock in the near term, as we know the company will be active in the market.

All in all, we see GOOGL.US as a stock likely to outperform world equity markets and cash over the medium-term.