Searching for the Future
In this edition of the Smart Investor newsletter, we examine one of the world’s most valuable companies. But first, let us delve into the latest Portfolio news and updates.
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Portfolio Updates
❖ General Dynamics (GD) reported its Q2 2024 results on July 24th. The report featured robust results, with a year-on-year increase in revenue of 18%, and a 21% jump in EPS. The company’s Aerospace segment saw sales of business jets double from last year, leading to a revenue surge of 51% within that segment. Despite blockbuster results, analysts were looking for an even better outcome, with the EPS missing expectations by $0.02 due to some delays in deliveries. However, several Wall Street analysts, including UBS and Wells Fargo, raised their price targets on the stock.
❖ Check Point (CHKP) stock surged after the company reported robust Q2 results and announced a new CEO. The company’s current CEO, founder Gil Shwed, will transition to the Executive Chairman role, while the CEO role will be assumed by Nadav Zafrir – a co-founder and managing partner at Team8, a tech VC fund – in December 2024. For the second quarter, CHKP reported revenue growth of 7% year-on-year, while EPS rose by 8.5%, surpassing expectations. The company also announced a $2 billion expansion of the company’s ongoing share repurchase program.
❖ Amphenol (APH) reported Q2 revenues and earnings above the analysts’ expectations. Revenues rose 18% year-on-year to a record high, and EPS increased by 22%. Following blockbuster quarterly results, APH increased its quarterly dividend by 50%, starting with the October payout. Several Wall Street analysts increased their price targets on the stock, applauding APH’s performance and the strategic acquisition of CommScope’s mobile networks business, which is expected to triple the company’s sales in the mobile networks segment.
❖ EMCOR Group (EME) released its quarterly results on July 25th. The electrical and construction services company’s revenues and earnings surpassed analysts’ estimates by a wide margin, with the EPS surging by 78% year-on-year. EMCOR lifted its revenue and EPS estimates for FY 2024 above the consensus outlook.
❖ Dover (DOV) reported Q2 revenue and earnings which topped analysts’ estimates, with EPS rising over 15% year-over-year on strong organic revenue growth and improving margin performance. DOV also raised its FY 2024 EPS guidance, saying that robust operational performance and strong bookings support its confidence in market demand.
❖ Shares of Super Micro Computer (SMCI) fell, together with its peers in the hardware and semiconductor industries. Besides the negative investor sentiment towards AI-related stocks in the past two weeks, Supermicro’s stock was under additional pressure after the company said it would present its fiscal Q4 results after hours on August 6th, skipping an earnings preannouncement. Notably, this does not indicate a worsening performance, as Supermicro’s FQ3 earnings weren’t preannounced as well, and the company’s EPS surged by 308% year-on-year in that quarter. However, we will focus on the report’s details for clues regarding the stock’s future direction. Although SMCI has gained ~170% since its purchase for Smart Portfolio, it has been a significant drag on the Portfolio’s performance since reaching an all-time high in March and then declining strongly from those levels.
❖ Howmet Aerospace (HWM) reported Q2 2024 results, which reflect a record quarterly revenue for the company after the top line rose 14% year-on-year. Both revenue and adjusted EPS exceeded analysts’ expectations, while operating income margin notably expanded. The robust performance was led by strong growth in the commercial aerospace market. HWM’s management raised full-year guidance, authorized an increase of the share repurchase program by $2 billion, and hiked its dividend by 60%.
❖ PayPal Holdings (PYPL) announced its second quarter 2024 results, featuring revenues and earnings considerably above estimates. Net revenues increased 8% year-on-year, while net income rose by 10%, and adjusted FCF jumped by 31%. Two important metrics for payment-processing companies, transaction margin dollars, and total payment volume, rose by 8% and 11%, respectively, from Q2 2023. The number of total active accounts demonstrated a slight sequential increase, supporting analysts’ opinion that PayPal has turned the corner and is now back on the path to profitable growth. Following the blockbuster quarterly results, PYPL boosted its FY 2024 earnings guidance and raised its share repurchase outlook.
❖ Merck & Company (MRK) reported its second-quarter revenues and earnings that strongly topped Wall Street expectations. The company’s top and bottom lines were supported by strong sales of its leading cancer drug Keytruda, as well as by growth in sales of its other drugs and vaccines. The pharmaceutical giant raised its full-year sales forecast. The company has lowered its FY24 profit guidance. The guidance cut was not read as concerning as it comes on the back of MRK’s product line expansion efforts, which include new drug development and acquisitions to offset the impact of Keytruda’s patent expiration in 2028.
❖ Arista Networks (ANET) reported robust results in the second quarter that were above Street expectations. The company’s revenue growth was driven by its services and subscription software, which comprised 17.6% of its revenues in the second quarter. Arista has forecasted third-quarter revenue above Wall Street estimates, anticipating strong demand for its networking equipment from cloud computing and AI applications. In the second half of the year, the company expects its growth momentum to accelerate as it sees strong demand for its equipment from cloud computing firms – who have benefitted largely from the AI boom.
❖ Arch Capital Group (ACGL) announced better-than-expected Q2 results with strong EPS due to favorable reserve development and better-than-expected net investment income. The company capitalized on difficult market conditions to strengthen its property and casualty insurance and reinsurance businesses. Furthermore, Arch’s underwriting business showed a solid performance in the second quarter, as underwriting income surged by 25.7% year-over-year. The combined ratio of its loss and underwriting expenses, excluding catastrophic activity declined by 3% year-over-year to 76.7%, showcasing the underlying profitability of the company.
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Portfolio Earnings and Dividend Calendar
❖ The Q2 2024 earnings season is in full swing, with many Smart Portfolio companies scheduled to release their results in the coming week. The reporting firms are KKR & Co (KKR), ITT Corp. (ITT), Regeneron (REGN), Vertex Pharmaceuticals (VRTX), Super Micro Computer (SMCI), and Airbnb (ABNB).
❖ There are no ex-dividend dates for Smart Portfolio companies in the next week.
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New Buy: Alphabet Inc. (GOOGL)
Alphabet Inc. is an American multinational technology conglomerate holding company headquartered in Mountain View, California. Alphabet is the world’s second-largest technology company by revenue and one of the world’s most valuable companies, ranking as #8 in the Fortune 500 list. With a market cap of $2.1 trillion and annual revenues of $307.4 billion, it is one of the “Magnificent Seven” technology market leaders.
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The Making of a Giant
The company was founded in 1998 as Google Inc. to market Google Search, which within a short time became the most-used web-based search engine in the world. Google replaced all other search engines thanks to the superiority of a search algorithm developed by Google’s founders Larry Page and Sergey Brin. Google search’s popularity was so sweeping that its name, “Google,” soon became the term for “web search.” Google held its IPO in August 2004.
Google grew and expanded at breakneck speed, expanding geographically and entering different business venues such as advertising, hardware, cloud, and many more, through internal R&D efforts along its 258 acquisitions. In 2015, Google changed its corporate structure and name, becoming Alphabet. This change was made to account for its growing areas of interest and to make the company more manageable.
By forming a holding company, Alphabet Inc. reorganized Google and its other companies into subsidiaries. This made it possible for the several divisions within Google that weren’t directly involved with its primary Internet services – such as health care, entertainment, transportation, venture capital financing, and artificial intelligence (AI) – to become nearly independent business units under the same corporate structure.
The goal of the semiautonomous structure is to provide cooperative efforts and pooled resources to enable business units to explore new paths. In addition, the separation of the operational structures of different units allows better risk management and higher financial transparency and facilitates product and service diversification. Besides, the separation allows GOOGL’s subsidiaries to focus on their specific businesses with greater efficiency and fewer bureaucratic bottlenecks.
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Multisector Tech Empire
Alphabet operates through three segments: Google Services, Google Cloud, and Other Bets. The Google Services segment is responsible for Android, Chrome, devices, Gmail, Google Drive, Google Maps, Google Photos, Google Play, Search, and YouTube. It also manages the advertising business, apps and in-app purchases, digital content, and consumer subscription services. Many of the segment’s offerings, such as search, mail, YouTube, and others, are undisputed market leaders.
The Google Cloud segment is responsible for Alphabet’s portfolio of offerings related to infrastructure, cybersecurity, databases, analytics, AI, and cloud-based communication and collaboration tools for enterprises. The segment is the direct competitor to Amazon’s AWS and Microsoft’s Azure. While it is currently a distant third with an 11% market share (vs. AWS’s 31% and Azure’s 25%), it has been growing faster than its rivals in recent quarters. In addition, the advance of AI increases the total addressable market potential overall, providing additional growth opportunities.
The Other Bets segment is the smallest, but the most diverse segment of Alphabet. It spans from fiber broadband offerings, smart homes, and AI research (by Google DeepMind) to various “moonshot” high-tech ventures in biotechnologies, self-driving cars, delivery drones, robots, and more.
Alphabet consistently ventures into emerging technologies and industries through a combination of new business acquisitions and heavy R&D investments. This strategy helps increase its diversification by providing a variety of products and services across a wide range of industries and niches, compensating for each other’s cycle stages. In addition, it helps avoid stagnation that often befalls profitable mature companies, and places GOOGL at the forefront of technological advancement.
Meanwhile, Alphabet’s core segments focus on their revenue-driving businesses, the “cash cows” of the firm. Google services platforms are a part of the daily lives of billions of people around the world, providing the firm with a steadily growing stream of revenues. Even though businesses like Search and Android hold dominant market shares, these business units don’t rest on their laurels, and constantly invest in innovation. For example, AI implementation is slated to increase advertising efficiency, ramping up income.
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Stellar Finances and Strong Earnings Growth
Alphabet’s financial health is more than perfect. Its debt, comprising less than 10% of equity, is minute relative to its cash and short-term investments of $108.1 billion. The interest it earns on its investments is about 30x the interest it pays on its debt. It is of no surprise, then, that the company’s S&P Global credit rating of “AA+” is second only to two U.S. firms, Microsoft and Johnson & Johnson.
GOOGL also excels in terms of capital efficiency and profitability. Its ROE, ROA, and ROIC, as well as its operating and net profit margins, are in the top 10% of its industry, while its FCF margin is in the top 20%.
The Internet media giant Google accounts for 99% of Alphabet’s revenues, with 89% stemming from Google Services and 10% from Google Cloud. The additional 1% of 2023’s revenues were derived from Other Bets. The parent company leverages its services and platforms for advertising, which comprises about 87% of its annual revenues. In the past five years, Alphabet’s revenues have grown at a CAGR of 17.2%, while its earnings-per-share rose at a CAGR of 23%, which can be considered very fast for a company of its size.
In the last reported quarter, Q2 2024, the tech giant revealed another set of robust results, led by strong momentum in Search and Cloud segments, which were significantly boosted by AI. Alphabet’s revenues rose 14% year-over-year, twice as fast as their first-quarter growth. Google Services revenues – including advertising, subscriptions, platforms, networks, and devices – rose by 12%, Google Search expanded by 14%, and Google Cloud’s top line surged by 29% from Q2 2023. Operating profit margins expanded further, reaching 32%, and EPS jumped by over 31%, exceeding estimates for the sixth straight quarter.
Despite concerns about ChatGPT’s potential adverse effect on Google Search, Alphabet’s global search market share remains comfortably above 90%, with the revenues from this segment continuing to increase steadily after the Generative AI tool’s launch at the end of 2022. Moreover, the company has demonstrated its ability to successfully compete in the cloud computing market, steadily increasing its slice of the pie. The ongoing incorporation of AI models across the company’s platforms – from search to software development tools – is already paying off. Alphabet’s CEO Sundar Pichai said that Cloud AI solutions have “already generated billions in revenues and are being used by more than 2 million developers.”
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Overblown Fears Create an Opportunity
Despite all these positives, Alphabet’s stock dropped post earnings, which came out at a difficult time for tech large-caps undergoing a shakeup in investor sentiment. Amid high expectations from AI leaders, anxious investors were spooked by a slightly softer growth in YouTube ads revenues (mostly caused by a tough year-on-year comparison), and primarily by the company’s announcement that capital expenses would remain high for the year after surging by 91% from the second quarter of 2023.
While outlays on AI development and implementation were and are expected to continue being massive, they are well-justified by the need to outpace competitors and secure Alpahbet’s position in the market. GOOGL’s AI competitors, Microsoft and Meta Platforms, are also pouring billions into the technology.
Most analysts also remain unphased regarding OpenAI’s “SearchGPT” prototype announcement, as several similar AI-based search summarizing tools already in the market have been gaining in popularity without posing a threat to GOOGL’s search business, as earnings show. Despite OpenAI’s ambitions and capabilities, it would be difficult to compete with Alphabet’s massive user base and data. Besides, GOOGL has already begun to roll out a retooled search that produces AI-generated conversational responses to search queries.
Alphabet is one of the best-positioned giants to capitalize on AI, with its enormous ecosystem of services, platforms, and hardware – providing an endless pool of customers. Besides, a company that indexes and stores enormous amounts of webpage data is surely more than capable of indexing and storing data about billions of user preferences.
The post-earnings sell-off in GOOGL stock, which most analysts see as way overblown, has created a very attractive entry opportunity for investors. The stock surged by over 56% from March’s dip to an all-time high on July 10th but gave back about 11% afterward. As a result, GOOGL is now trading at the lowest valuation among its Magnificent Seven peers, also featuring a notable discount versus its historical PEs. Based on projected cash flows, Alphabet’s stock appears to be undervalued by about 30%.
In addition to the stock-price appreciation, Alphabet’s shareholders are compensated through dividends, which the company began paying in June, and generous share buybacks. The company is working through a $70 billion share repurchase authorization, having bought its shares for almost $25 billion in H1 2024 alone.
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Investing Takeaway
Alphabet is one of the largest and most valuable companies in the world, holding significant shares in its multiple markets. GOOGL is a cash-rich, high-margin business with a proven ability to consistently deliver profitable growth and robust shareholder returns. We view the recent fears regarding its AI Capex as exaggerated, as these investments are necessary to cement Alphabet’s position as an AI leader. However, these investor concerns have created an attractive opportunity for exposure to the stock of one of the best companies in the world.
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New Sell: Visa, Inc. (V)
Visa is an American multinational payment services corporation; it is a global leader in digital payments, operating the world’s largest credit and debit card network. Visa and its main competitor, Mastercard, form a global payment duopoly, with the two companies accounting for 90% of all global payment processing outside of China. This market domination naturally gives these firms, and specifically Visa as the larger of the two, an enormous competitive advantage thanks to network and scale effects, which also provides a buffer from competition.
This leading market position, supported by Visa’s stellar finances and industry-winning profitability and capital efficiency metrics, has led to increased investor expectations in terms of revenue and earnings growth. As a result, the company’s stock tumbled after its FQ3 2024 report revealed a revenue miss – a rare occurrence for the financial behemoth. Earnings in the quarter came in line with estimates, which haven’t been enough to outweigh the negative revenue news.
The revenue miss was not large, but its details spooked investors, as it came as a result of a slowdown in payment volume growth, which is not expected to reverse in the next several months. In the U.S., high interest rates weighed on consumer spending, with the spending cutbacks especially pronounced among lower earners. In addition, international transaction income was impacted by a macroeconomic slowdown in Asia and higher currency volatility.
Although Visa maintained its revenue growth guidance for the full fiscal year 2024, higher currency volatility and weak macroeconomic conditions in China are expected to continue adversely affecting performance in the ongoing FQ4 2024. In addition, weakness in several Asian currencies, particularly the Japanese yen, is slated to continue impacting outbound travel and purchase volumes from these regions, in contrast to the outlook given earlier in the year.
Although the U.S. payment volume growth should improve once the Federal Reserve starts reducing interest rates, the expected beginning of the monetary easing in September doesn’t leave Visa enough time for a material FQ4 performance boost. In addition, the expected 0.25% rate decrease may not alter significantly the consumer spending trends, specifically given the cooling labor market and still-high food and shelter inflation, which have larger effects on Visa’s lower-earning customers.
Meanwhile, according to analysts, to achieve FY24 targets the company will need to reach at least low double-digit revenue growth this quarter. Given the above stated trends, analysts are uncertain that the payments giant will be able to meet its forecasts. While Visa’s balance sheet and margins would be the envy of most companies, prior to the earnings report markets priced in significant growth and strong performance, with these assumptions now being questioned.
As a result, Wall Street analysts, including those from J.P. Morgan, Argus Research, Oppenheimer, Wedbush, and others, have reduced their price targets on the stock. While Visa’s rating remains a “Strong Buy,” reflecting its market dominance that should support the stock in the long term, it may see some turbulence in the months ahead, with the biggest risk being FY24 underperformance. We plan to revisit this payment services leader in the future, but for now, we find it prudent to sell the stock.
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Portfolio Stocks Under Review
❖ PayPal (PYPL) has been removed from the list of stocks under review for potential sale, following its strong Q2 2024 results and improved outlook.
❖ We are placing Airbnb (ABNB) under review until earnings, which are expected to be released on August 6th. The stock has been a drag on the portfolio’s performance, despite mostly positive earnings expectations after ABNB surpassed analysts’ EPS estimates in 11 out of 12 last quarters. The stock’s underperformance mostly results from a shaken sentiment amid several regulatory and legal developments that may potentially impact revenues, as well as a public backlash against short-term rentals in some of the most popular European tourism destinations.
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Smart Investor’s Winners Club
*The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.
Despite the turbulence in the technology shares in the past weeks, the list of Winners has expanded to 16 stocks: GE, SMCI, AVGO, ANET, EME, TSM, ORCL, AMAT, CHKP, APH, VRTX, GD, ITT, TPL, PH, and AIT.
The next in line to enter the lucrative club is HWM with a gain of 25.8% since purchase. Will it close this minute gap, or will someone else outrun it to the finish line?
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Smart Investor Portfolio
| Portfolio YTD Return |
Portfolio Volatility (Beta) | Portfolio Dividend Yield |
| 19.20% | 1.14 | 0.65% |
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Disclaimer
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