Monday, March 16, 2020

Alphabet's Cash Hoard Is Destroying Shareholder Value

Mar. 16, 2020 7:14 PM ET
About: Alphabet Inc. (GOOG), GOOGL, Includes: AAPL, AMZN, BRK.A, BRK.B, SPY


Long only, value, growth at reasonable price, research analyst

This article explains why Alphabet should aggressively execute a leveraged recapitalization.

Just as Apple has successfully done, Alphabet should achieve a cash neutral position, especially as interest rates continue to plummet.

Alphabet's current share repurchase program is not enough and needs to be accelerated based on the growth of its free cash flow.

I remain very bullish on Alphabet. Today, I rate Alphabet a strong buy.

Investment Thesis

Alphabet (GOOG) (GOOGL) is presently a buy for reasons enumerated in this article and this article. Today, I am here to discuss course of action that Alphabet's management should take following the departure of its founders, so as to maximize shareholder returns over the coming decade. Simply put, Alphabet's management should embark on a leveraged recapitalization to ensure that management acts in the best interest of shareholders and to return some of the massive cash hoard the company has built, which is also projected to grow at an accelerated rate in the next decade.

Here's the "problem" we, as investors in Alphabet, face:

Source: YCharts

Source: YCharts

The above metrics illustrate the issue Alphabet's facing. There's simply too much money, and it's growing too rapidly to be properly stewarded. These may not sound like issues, but as I will explain, this prosperity can lead to severe shareholder value destruction, especially when visionary founders depart companies, which has become the case for Alphabet. The company is no longer in the hands of someone like Jeff Bezos and Warren Buffett. It is now in the hands of new management, and as such, the company's actions must be monitored aggressively. One tool for such monitoring is the execution of a leveraged recapitalization, which is what Apple (AAPL) has executed over the past 5 years.

Were Alphabet to execute a leveraged recapitalization, it would unlock substantial shareholder value. In this article, I discuss what such a leverage recapitalization could generate in the way of returns. I also explain why such financial engineering would accelerate the bullish narrative for the company.

But first, let's discuss what a leveraged recapitalization entails.
What Are Leveraged Recapitalizations?

A leveraged recapitalization usually entails a company willfully taking on debt, while simultaneously returning excess cash to shareholders through either dividends or buy backs. Leveraged recapitalizations are especially useful and necessary when a company generates too much excess free cash flow, and an agency problem begins to arise. The agency problem refers to the idea that managers of the company might have objectives and incentives that create a conflict of interest: do what's best for shareholder value maximization in the long term or do what's best for manager's stock options or corporate travel plans. One of the ways to alleviate this problem is to ensure managers do not have enormous excess cash with which to make poor decisions, such as lavishing money on unnecessary expenses, spending on financially senseless projects, or empire building.

In essence, Alphabet's leveraged recapitalization would achieve three objectives:
Reduce the amount of cash with which managers can make poor investment decisions, such as decisions that involve empire building or unnecessary expenditures.
Maximize the value of the firm by increasing interest expense such that it creates a tax shield and reduces WACC, thereby maximizing the value of the firm.
Return excess cash to shareholders.

In this article, I address each of these objectives in detail, then I communicate what I believe to be the best method by which Alphabet could execute this leveraged recapitalization, i.e., how might Alphabet return capital to shareholders in the most shareholder value accretive manner.
Objective 1: Ensuring Managers Act In Shareholders' Best Interest

A leveraged recapitalization ensures managers act in shareholders' best interest by reducing the amount of cash they have to spend frivolously on, for example, empire building, i.e., bad or overpriced acquisitions. In essence, the act of a leveraged recapitalization reverses the mindset of "we're so successful that money doesn't matter." Instead, managers think, "But would that really be the best use of our limited resources?" The latter of which was what created Alphabet; the former of which could lead to its demise.

In the case of Alphabet, the company currently has $120B worth of cash on its balance sheet, $30B in receivables, and its generating over $25B worth of additional cash (for which there seems to be no destination) each year. Further, $25B is also set to continue to grow by at least 15% each year. Now, some of you might be thinking, "This is the exact scenario Berkshire Hathaway (BRK.A) (BRK.B) faces, and it wouldn't have been wise for them to execute a leveraged recapitalization in light of the recent market decline." This is a valid statement to make, but it eschews one of the primary purposes of the leveraged recapitalization, which is reducing the agency problem inherent to the shareholder-management relationship. In the case of BRK, its original management, where certainly no agency problem exists, still controls the capital of the company and its decisions. If anything, BRK is more discriminating in its purchases than ever, though this will certainly not always be the case once Warren Buffett and Charlie Munger pass away (which will be a tragic day for the investing community to be sure).

In the case of Alphabet, it no longer has its founders at the helm; therefore, we can't be certain that management will always be perfectly aligned with shareholders' interest. I am not ascribing intent to management to be clear. This is simply a well-documented, common occurrence in business, that is, the agency problem.

Essentially, we're addressing this issue via a leveraged recapitalization. The company has grown too big and successful for its own good. Its wealth and success will actually be its undoing, unless we artificially reduce cash flows and cash hoards.
Objective 2: Maximizing Firm Value

The second objective is more theoretical than anything, but I thought I'd include it so that my readers could learn something new. The theoretical method by which academia values a company is to take the present value of all future cash flows to the firm, discounted by the firm's WACC.

When an equity heavy company executes a leveraged recapitalization, they can reduce their WACC such that the value of their firm is maximized. This occurs because with a lower WACC, i.e., discount rate, the present value of the firm's future cash flows is higher. Now, the calculations for this can be actually quite cumbersome, though very straightforward, so I am not here today to tell Alphabet the exact level of debt it should take on, as that must be ascertained by its corporate finance team through a thorough sensitivity analysis. However, I am here to highlight the fact that many of Alphabet's bonds have coupons below 3%, and with interest rates collapsing, it could likely borrow tens of billions of dollars at 2% or lower.

WACC is reduced when the rates on bonds that the company issues is much lower relative to the rate of return investors demand on its equity, which for most equity investors should be at least 10% or the average annualized rate of return from SPY (SPY).

Further, Alphabet could lower its annual tax burden by issuing bonds. The interest on the bonds is tax deductible; therefore, Alphabet could strategically reduce its tax burden, while maximizing its firm's value and returning massive amounts of cash to its shareholders. As I mentioned, this requires thorough and rigorous consideration in the form of a sensitivity analysis that only Alphabet's finance team could truly create, so I will leave it to them; however, I am here today to shed light on the fact that Alphabet needs to consider these options as its cash hoard begins to grow closer to $200B over the next 2-5 years.
Objective 3: Return Excess Cash To Shareholders

There truly has not been a better time for Alphabet to execute an ASR (Accelerated Share Repurchase). Alphabet is trading at nearly a 50% discount to its intrinsic value, which I detailed in this article. It would be inexcusable for the company to not take advantage of the present market panic. Alphabet's YouTube and Google properties will only strengthen during the virus panic, as many Americans sit at home using them frenetically, awaiting the all clear from the government and their places of employment.

Yes, I acknowledge that businesses may have to slash their ad budgets, on which YouTube and Google rely, but this will last at most 1-2 months before business as usual resumes.
What It Would All Look Like

Such a leveraged recapitalization would essentially mirror Apple's; in that, Alphabet should strive to reach a net cash neutral position. In doing so, Alphabet would either add $50B worth of extremely cheap long term debt, or it would reduce its cash position by, for example, $20B and add $30B worth of long term debt.

Regardless of Alphabet's choice, it should return $50B worth of cash to shareholders over the next one to two years. In light of the present economic turmoil, which should marginally impact Alphabet's revenues, Alphabet's shares trade at an enormous discount to the company's intrinsic value. In the article I shared above, I estimated that Alphabet's fair value lies somewhere around $1.6T. Currently, Alphabet trades at an approximately 50% discount to this number; therefore, a more aggressive accelerated share repurchase program is strongly warranted.

At the end of Alphabet's last quarter, it has ~$20B worth of its share repurchase program left to execute. Executing my proposed leveraged recapitalization would create a $70B share repurchase program, $50B of which could go to the ASR.

Below we see the results of Alphabet's recent share repurchase program, which I fully support as the company has traded at well below its intrinsic value, even while the market was at all time highs, and while the company continues to grow its already massive cash hoard.

Source: YCharts

In my proposed ASR, Alphabet would reduce its share count by 8.5% this year alone, which would not only be extremely accretive to shareholder value but also extremely positive for confidence in the market as a whole, as Alphabet makes up a significant portion of the S&P500, relatively speaking.

The result of Alphabet's leveraged recapitalization would be a company that's at a net cash neutral position; and henceforth, the company should return excess cash to shareholders immediately in the form of a buy back, so as to keep the company as lean and nimble as possible, and so as to keep management as disciplined as possible as Alphabet reaches points of unprecedented prosperity.
Concluding Remarks

I am extremely skeptical of Alphabet due to its enormous success and its lack of founder direction. Google Properties, Google Cloud, and YouTube are staples of global society, sans Russia and China, and have come to serve as the world's information superhighways. My point is that they are not going anywhere anytime soon and will continue to generate massive, growing free cash flow. Alphabet needs to instill financial discipline within the company by executing this leveraged recapitalization aggressively over the coming 2-5 years, else the company find itself a victim of its own success.

In closing, I want to be very clear about why Alphabet needs to execute my proposed plan so as to unlock trapped shareholder value. Alphabet does not have the visionary leadership at its helm, as was the case when Larry and Sergei were at the helm. It is not Amazon (AMZN), nor is it Berkshire Hathaway, where the original founders still remain, and where the agency problem is much less an issue. I also want to be clear that I believe in Sundar Pachai as the CEO of Alphabet as much as I believe in CEO Tim Cook, but one has a plan to ensure the company remains lean, efficient, disciplined, and nimble. I'm also not advocating that Alphabet reduce its R&D or CAPEX so as to return capital to shareholders, but I am demanding that it immediately return excess free cash flow to shareholders in the period, or following period, in which the money was earned.

If Alphabet executes the above financing plan, shareholder value will be maximized and continue to soar, thereby making Alphabet a screaming buy as of today's price of $1200. If it allows its cash hoard to build to unprecedented levels, while the company hopes its managers (who are not its visionary founders) can properly steward what will become $100s of billions into fruitful endeavors, then there will almost certainly be shareholder value destruction.

I am a long term holder of Alphabet, and I believe the company is still on track to be a multi-bagger, so long as the board ensures that shareholder interests are foremost at the company, and only secondary to Alphabet's customer interests.

As always, thanks for reading; let me know what you think; remember to follow for more, and happy investing!

Disclosure: I am/we are long GOOG, AMZN, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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