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Motley Fool Issues Rare “All In” Buy Alert
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A big trend in the technology industry this year has been rationalizing expenses and employee layoffs. Companies like Meta Platforms and Amazon have begun letting large chunks of their employee base go after realizing they hired too many people in 2021 and years prior. So far, technology giant and trillion-dollar enterprise Alphabet (GOOG -2.01%) (GOOGL -1.88%) has avoided such layoffs and — perhaps surprisingly — has added over 36,000 new employees over the last 12 months.
TCI Fund, a large shareholder of Alphabet stock, recently wrote to its management team in an effort to rein in its employee costs to improve profitability. Does that make Alphabet stock a buy today?
The TCI letter is short, straightforward, and brings up some reasonable points for Alphabet’s executive team to consider. First, the fund thinks Alphabet’s headcount is simply too high. Alphabet is the owner of assets like Google Search, Google Maps, and YouTube, which are all highly scalable and rely on outside sources to fulfill both supply and demand. Yes, these assets are extremely complex, but TCI thinks they can be run much more efficiently. The evidence is in Alphabet’s employee count growth. From 2013 to 2017, employee count grew by 14% annually. But then, inexplicably, from 2017 to the third quarter of 2022, Alphabet accelerated hiring and grew employee count by 20% a year, more than doubling over that time frame.
Second, TCI presented some data showing that Alphabet spends much more per employee than other technology peers. In 2021, median compensation at Alphabet was roughly $296,000 a whopping 67% higher than at competitor Microsoft. Yes, Alphabet employs some of the smartest people in the world who deserve to be paid well, but so do the other large technology companies. There’s no reason for Alphabet to pay them more for equivalent positions.
To sum things up, TCI thinks Alphabet has an easy path to raising margins by laying off some employees and reducing salaries. According to its analysis, a 40% operating margin at Google Services (which excludes Other Bets and Google Cloud) is easily achievable. For reference, last quarter the segment had a 25% operating margin, even with all this employee and compensation bloat.
Let’s do some rough analysis to see how a change in employee costs and a 40% operating margin could impact Alphabet’s earnings. Over the last 12 months, Google Services brought in $255 billion in revenue. At a 40% operating margin, that would equate to $102 billion in operating income, which is significantly higher than the $78.5 billion in total operating income Alphabet has brought in over the last 12 months.
Of course, this doesn’t include Other Bets and Google Cloud, which are both money losers for Alphabet at the moment. But Google Cloud is inching closer toward profitability and growing revenue at a fast rate (37.6% year-over-year growth in Q3 2022). Other Bets is a huge money loser, with $20 billion in cumulative losses over the last five years. TCI is recommending Alphabet pull back some expenses over at Other Bets in order to improve consolidated profitability as well.
I think if Alphabet goes through some of TCI’s cost-cutting ideas it will be great news for the stock. At today’s prices, the stock has a market cap of $1.27 trillion. Excluding Google Cloud and Other Bets, and assuming Google Services could hit $102 billion in annual profits, the stock would trade at a price-to-operating income (P/OI) ratio of around 12.5, which is much below the market average. Plus, Alphabet has over $116 billion in cash on its balance sheet that it can return to shareholders through share repurchases.
For a company with a consistent track record of growing its revenue and a dominant position as one of the leading technology companies worldwide, Alphabet stock looks like an easy buy at these prices.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Meta Platforms, Inc., and Microsoft. The Motley Fool has a disclosure policy.
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