The Henry Fund Henry B. Tippie School of Management Juhi Narang

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1 The Henry Fund Henry B. Tippie School of Management Juhi Narang Google Incorporated (GOOG) October 10, 2017 Information Technology Internet Information Providers Stock Rating Buy Investment Thesis Target Price $ Henry Fund DCF $1,185 Henry Fund DDM NA Relative Multiple $861 Price Data Current Price $1, wk Range $ Consensus 1yr Target $1, Key Statistics Market Cap (B) $ Shares Outstanding (M) Equity Risk Premium 4.8% Model Beta 0.98 Dividend Yield 0.00% Est. 5yr Growth 15.5% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 5.60 Price/Book (mrq) 4.64 Profitability Operating Margin 26.27% Profit Margin 21.58% Return on Assets (TTM) 15.26% Return on Equity (TTM) 18.53% Alphabet Inc. (GOOGL), established itself as the leader in online search and advertising sales. The strong revenue growth forecast of CAGR 15.5% during forecast horizon ( ) coupled with estimated 14.6% upside for the stock are the drivers for the buy recommendation for the stock. Drivers of Thesis As the number of online users increase, digital ad spending will increase primarily benefiting Alphabet, being the market leader Search traffic shift from desktop platforms to mobile platforms will continue to generate top-line growth due to dominant market share of Android. We expect the revenues will rise 17% in 2017 and 2018 primarily driven by pricing improvements with opportunities related to mobile, video (YouTube, in particular) and cloud, and related improving pricing trends Alphabet continues to focus on long-term and sustainable growth opportunities by investing in innovation and research and development Risks to Thesis Alphabet is investing heavily in capex towards high-risk projects and bets which may or may not generate revenues ever There is no diversification in the revenue stream for Alphabet as more than 99% of revenue comes from advertising Facing intense competition in digital advertising space that could harm Google s dominant position and pressurize the operating margins 40 GOOG Sector Source: Yahoo Finance & HF estimates Strengthening U.S. dollar can have a negative impact the top-line growth for the company as more than 50% revenue is earned outside US. Earnings Estimates Year E 2018E 2019E 0 EPS $21.37 $23.78 $28.18 $30.60 $35.97 $41.96 growth 11.10% 11.30% 18.47% 8.60% 17.56% 16.65% 12 Month Performance Company Description 30% 25% 20% 15% 10% 5% 0% -5% -10% GOOG S&P 500 Source: Yahoo Finance O N D J F M A M J J A S Important disclosures appear on the last page of this report P/E ROE EV/EBITDA Alphabet Inc. is now a holding company of subsidiaries such as Google Inc., Nest Labs, Google Capital, Google Fiber Inc., Calico LLC, Sidewalk Labs LLC, and of operating divisions that include Verily and Google X. Alphabet includes Google Maps, YouTube, Chrome and Android, as well as less-related assets such as connected-home company Nest, the company's investment arms and many emerging "moonshoot" initiatives.

2 EXECUTIVE SUMMARY Alphabet Inc. is the holding company of the world s largest internet search provider, Google Inc. The company is headquartered in Mountain View, California and has over 75,606 employees as of Google was founded in 1998 and had its initial public offering in The company has grown to such an extent that the word "Google" is now become a synonym for the Internet search category. There has been 20% Y-o-Y growth in advertising revenue in 2016(1), which demonstrates that the firm is providing value to the marketers. After a detailed study of the end market demand drivers, the 5-year CAGR for revenue was estimated to be 16% during the forecast horizon ( ). Ad spend is expected to grow 15% YoY until 2019 and GOOGL will share majority portion of this growth. (3). This estimated top line revenue growth coupled with Alphabet s plan to heavily invest in research and development activities are the major drivers of the DCF model used to compute the intrinsic value of Alphabet s stock. The model suggests a 15% upside on the current stock price, which is the driver for the Buy recommendation for Alphabet. COMPANY DESCRIPTION Alphabet Inc. is involved in building useful and engaging products that enable people to connect and share through various channels such as mobile devices, personal computers, and other surfaces enabling people discover and learn about current happenings in the world around them, share their opinions, ideas, photos and videos, with public at large, and stay connected everywhere. Alphabet dominates the online search market that generates strong revenue growth and cash flow with Google s global market share of above 77%. We expect continuing growth in the company s cash flow as the company has focused on its search segment, and the acquired market share leadership in many countries around the world. Its efforts to broaden its reach and innovation initiatives have increasingly attracted users and spur activity and engagement. Revenue Decomposition Revenue Breakdown by Segment (FY 16) (%) Source: 10K (1) 99% Google Segment (Advertising and Other) As seen in the chart above, 99% of Alphabet s revenue comes from Google Inc. (advertising and others). Google s core products such as Search, Android, Maps, Chrome, YouTube, Google Play, and Gmail each have over one billion monthly active users(1). 1% % Google (advertising & other) % Other Bets Performance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Google gets paid when a user engages in their ads. In this case, AdWords, is the primary auction-based advertising program offered by the company. Source: Smartinsights.com Brand advertising helps enhance users awareness of and affinity with advertisers products and services, through videos, text, images, and other interactive ads that run across various devices. Page 2

3 We expect this revenue to grow at a CAGR of 16% in forecast horizon ( ) and expected to still be 99% of total Alphabet s revenue. The success of this revenue segment directly depends on its product s ability to increase user engagement. All these ads are strategically placed by Alphabet as the company has big user data from its search engines, that it analyzes to drive its advertising revenue. These ads let marketers reach people based on a variety of factors including age, gender, location, interests, and behaviors. Increasing internet penetration around the globe is one of the most important aspects for the growth of the company. Other Bets Alphabet s Other Bets are early-stage businesses, which come with considerable uncertainty, but they are already making important strides in their industries. During the forecast horizon ( ), the Other Bets segment of Alphabet is expected to grow at 18% CAGR, but is still expected to contribute less than 1% of the total revenue during the forecast horizon. Target Market and Geographic Presence: In fiscal year 2016, Alphabet generated around 47% of its revenue is from the US, 44% from Rest of the world and 9% from UK. (1) Geographic Revenue Distribution Source: Statista Globally, the number of internet users has grown by 7.5% from 2015 to 2016 and is expected to grow at 6% in our forecasted period (5). The company expects that the end market demand for Google products in the rest of the world like India will lead to revenue growth for Alphabet. India, Brazil, Indonesia, and other emerging countries is expected to drive Alphabet s revenue globally. Whereas, in China it is difficult to grow because its difficult to replace Baidu in China. 44% 47% Google Segment Revenue Decomposition of Google Segment 9% Domestic Revenue % UK Revenue % Rest of the World % The largest subsidiary of Alphabet Inc., Google is the driver for the advertising and licensing revenue. The google segment itself is divided in three sections: Google websites, Network Member s websites, and other revenue. Below is the revenue decomposition for Google Inc: Source: 10-K Page 3

4 Revenue Decomposition of Google Inc. Source: 10K (1) 17% 11% % Google Websites 71% % Network Members's Websites % Other Revenues From the chart above, we see that Google websites contribute 71% of entire Google s revenue and Alphabet s revenue which is the highest. AdWords AdWords is a primary auction-based advertising program that enables Google s advertising customers to bid for key search terms. If the customer s bid is successful, then the customer s ads are displayed next to the search results. This platform helps create simple text-based ads that appear on Google properties and the properties of Google Network Members. There are two different terms that measure the click driven revenue: - Paid Clicks and Cost Per Click Paid Clicks Paid Clicks represent engagement by users and include clicks on advertisements by end-users shown by Google on its websites, products and its network websites Cost per Clicks (CPC) CPC is the average cost of each engagement by users that Google charges its advertisers calculated as: Google websites Google websites include any product owned by Alphabet such as Translate, Search, YouTube, Maps, Finance, Shopping, Gmail, and range of other internet products. Network Member s Websites Google Network Members properties revenues consist primarily of advertising revenues generated from ads placed on Google Network Member properties through: AdSense (such as AdSense for Search, AdSense for Content, etc.); AdMob; and DoubleClick AdExchange. (1) In 2016, the growth in revenue from this sector was primarily driven by strength in programmatic advertising buying as well as strength in AdMob, offset by a decline in our traditional AdSense business. Network Member s Websites Google other revenues consist primarily of revenues and sales from Apps, in-app purchases, and digital content in the Google Play store; Hardware, Licensing-related revenue and service fees received for our Google Cloud offerings. Changes in Paid Clicks and Cost per Clicks (CPC) 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% Changes in Paid Clicks and Cost per Click 22% 32% 27% Paid clicks change -11% Source :10K and Henry Fund Estimates Cost-per Click -11% (Estimated) -11% Page 4

5 As seen from the chart above, we see that in the Google segment, over all paid clicks grew by 32% in 2016 and we expect click driven revenue to grow by 27% in the forecasted period which means a promising growth rate in user engagement. Whereas, the cost per click has been declining at a rate of 11% YoY in past years and expected to go down in forecasted period. The current cost per click for Google AdWords is between $1 and $2 and the average CPC on the Display Network is under $1. (4) One of the reason for decline in cost-per-click was continued growth in YouTube engagement ads where cost-per-click remains is lower than other advertising platforms. The lower CPC is also a result of changes in device mix, property mix, product mix, geographic mix, and ongoing product changes. We understand that a shift in product mix from desktop devices to mobile phones is also one of the biggest factor that has an impact which is detailed further in the industry trends section. Cost Structure 80% 70% 60% 50% 40% 30% 20% 10% 0% 71% Source 10-K (1) Revenue and Cost STructure (FY 2016) 17% Google properties & TAC rate 17% 31% Network Members & TAC rate 12% 52% Other revenue & cost of revenues (playstore, licencing, hardware) % of total revenue % of total cost of revenue From the chart above, we see that Google websites earn the highest percentage of revenue and has the lowest percentage of Traffic Acquisition Costs to total cost of revenue. The biggest cost for Alphabet is in terms of Cost of Revenue is Traffic Acquisition Costs (TAC) - costs associated with gaining advertising revenue. This also includes the revenue share that Google promises its network members and distribution partners for hosting Google s advertisements. Moreover, Google Websites contribute the most to the gross margin line of Alphabet. The acquisition costs for network members, distribution partners, and costs of hardware products are significantly higher. Other segments/subsidiaries Alphabet has subsidiaries Google Ventures and Google Capital that are the venture capitalist and the private equity firms that invest in promising technologies and startups like Uber, Survey Monkey and Glassdoor. The investments made by these subsidiaries are treated almost as long term and short-term investments of cash. Subsidiary X is invested in research work on futuristic ideas like hot air balloons beaming internet around the world (Project loon), self-driving cars, Project Wing (product delivery using flying vehicles, and various other futuristic projects. The CapEx for the Research and Development of this subsidiary has been incorporated in the model for the forecast period. Verily is an independent subsidiary that is involved in research and study of life sciences and working on projects like detecting glucose level through contact lenses, health tracking wristbands, advanced surgical robotics, etc. The revenue and costs for this subsidiary are difficult to estimate and have a high degree of uncertainty due to which we have not factored them in our DCF model. The Henry Fund team has abstained from factoring in the revenue potential of any of these projects into the model while factoring in the costs and the capital outlays needed. This is because almost all of these projects are disruptive technologies that will create new markets and hence cannot be factored in with any degree of certainty. If any Page 5

6 Revenue in Billions Surprise History (%) Net Income (B) Surprise History (%) of these projects are successful, the intrinsic value of the stock will increase drastically. Shares Classes and Voting Rights Source: 10-K Alphabet Inc. has issued shares of different classes with different voting powers. From the table we can see that Class B shares, that are not traded in the market, have the highest control and are the most powerful shares. Almost 93% of these class B shares are owned by Sergey Brin, Larry Page, and Eric Schmidt which gives them the power to exercise significant control over management and all affairs requiring stockholder approval. In the past these people have put in efforts to ensure the growth and vision of Alphabet stay intact which will in future too drive the company growth. The Class C shares with no voting rights are used to fund employee equity incentive programs. Earnings Release (7) Shares Number of Outstanding votes % of control Class A 298, % Class B 47, % Class C 347, % RECENT DEVELOPMENTS Quarterly Results - Revenue Actual Mean - Analyst Estimates Beat/Miss The chart above demonstrates Alphabet s recent quarterly revenue results and the surprise history as compared to the analysts expectations. Q2 revenues of $26 billion (+21% YoY) and YTD total revenues of approximately $50 billion (23% YoY) can be attributed to a significant increase in mobile search and a strong contribution from YouTube. Network Revenues from Cloud, Play, and hardware grew substantially as well. The Henry Fund team believes that Alphabet is poised to grow its top line by 16% YoY during the forecast horizon Source: Sentieo Quarterly Results - Net Income Q1 17 Q2 17 The chart above demonstrates Alphabets outperformance as compared to analysts estimates for net income. Alphabet has seen a significant increase in its total cost of revenues (+28%YoY) and other cost of revenues (+ 27% YoY). This has been driven by Google expenses, specifically, costs associated with operating datacenters (depreciation, content acquisition costs primarily for YouTube and hardware related costs). Despite this increase in costs, the YTD operating margin has increased 15% YoY. This has been mainly driven by the robust top line growth. The Henry Fund team believes that the cost of revenues of Alphabet will increase during the forecast horizon, especially with the increased investments in its other bets, but the ensuing top line growth will help maintain and expand its healthy operating and net income profit margins Actual Mean Beat/Miss 23 Source: Sentieo Q1 17 Q Page 6

7 Flagship launches (Android vs ios) Apple Inc. announced the launch of its flagship products iphone X, iphone 8, and iphone 8 plus in Q while Google announced the release of Pixel 2 in Q The smartphone market is getting increasingly saturated and CAGR growth of the mobile phone market during the next 5 years is expected to fall from 12% to 6-9%. This prompted an analysis on the on the expected market share for android vs ios operating systems. The chart below reveals that Android is expected to maintain its leadership in terms of the market share for smartphone operating systems % 80.00% 60.00% 40.00% 20.00% 0.00% Market Share by Operating Systems E 2019E 2020E Android (%) ios(%) Windows Phone(%) Other(%) With over 2 billion monthly active Android devices around the world and over 82 billion apps downloaded from Google Play annually, the Henry Fund team believes that Alphabet s historical licensing revenue growth of 6-6.5% will continue during the forecast horizon. Google Cloud Platform Google Cloud has added several high-profile customer logos in FY Some of these customers include Verizon, Colgate, ebay, and The Home Depot. Despite the aggressive investments in popularizing its cloud platform, Google still comes a distant third in terms of market share in the infrastructure as a service market (IaaS). Amazon s AWS and Microsoft s Azure still dominate more than 70% of the public cloud space. Source : skyhighnetworks.com(20) The Henry Fund team is cautiously optimistic of GCP s potential in the public cloud space. The public could market (IaaS) is expected to grow at a 29% CAGR to reach $ 72 billion by 2021 and we expect Alphabet to increase its market share from 3% to 10% during the forecast horizon. This is one of the major drivers of the 16% top line growth forecasted for Alphabet during the forecast horizon. Other Bets Installed base distribution by platform GCP 3% Others 26% Azure 29% AWS 42% In Q2 17, Other Bets revenues were $248 million primarily generated by Nest, Fiber and Verily while generating an operating loss of $772 million. Alphabet s other bets, including the ambitious moonshot projects have historically been loss making, and we do not expect this to change during the forecast horizon. This doesn t mean that they will never be profitable. It is just that they spend money on Research and Development and some products are not revenue positive yet. Waymo, the subsidiary that develops technology for the self-driving cars at Alphabet announced a deal with the ride sharing company Lyft to develop and productize ride Page 7

8 sharing autonomous vehicles. The Henry Fund team does not expect a major product roll out from Waymo during the forecast horizon and has hence only modelled Capex and no revenues for Waymo. Other than Nest, Fiber, and Verily, most other bets of Alphabet do not generate revenue and this has led the team to model Capex at historical levels ($152 M per quarter) while having a conservative outlook on the revenue potential. percent of overall internet consumption that will be mobile in 2017(15). Videos Videos are becoming very effective way of advertisement. The study, conducted by Advertiser Perceptions for the Interactive Advertising Bureau (IAB), suggests that mobile video advertising this year has increased by 67% from 2015 (16). Mobile Ad Spending INDUSTRY TRENDS Source: Digiday (15) Source: Recode(14) The graph shows that Ad spending on mobile video will reach $18 billion next yearglobally, surpassing desktop As per the chart above and recent studies prove that mobile is driving most ad spending growth worldwide and by 2019, advertisers will spend more on mobile than all traditional media, except television, put together. Internet and mobile marketing allows notable targeting and data-focused return-on-investment capabilities and hence, mobile has now accounted for more than half US digital advertising sales in This has been a result of growing adoption of technologies such as powerful Internet-enabled smartphones and tablets is a positive for interactive advertising. The industry generally has priced mobile advertising at lower rates than online advertising, but Henry Fund team expects to see an increase in pricing with improving trends. Mobile-based impressions and clicks are primary growth drivers for digital advertising and Google and Facebook still have the biggest market share in mobile advertising. 71 Source: Digiday (15) Page 8

9 Online video advertising currently makes up 28 percent of all digital display ad spending, up from 21 percent in That s expected to rise to 30 percent next year and 31 percent in MARKETS AND COMPETITION Alphabet is in an industry characterized by rapid change as well as new and disruptive technologies. These companies compete based on technological innovation and expertise. The companies in internet search and social media networking have an area for expertise such as Facebook specializes in social media networking, Alphabet and Baidu specialize in search and Microsoft in enterprise software solutions. This specialization helps the companies grow and sustain in high competitive environment. highest market penetration in the last quarter of Alphabet sees Facebook sees as its biggest competitor in this segment due to their user growth. Peer Comparisons The closest competition to Alphabet in search is from Microsoft s Bing. Both the companies are investing heavily in Research and development to develop technologies to gain competitive advantage over the other. Currently Bing is at a disadvantage because it does not have significant presence in the mobile market as of now that is one of the main growth drivers of the search ad market. Source: Sentieo Edge Equity Terminal From the chart above, we can see that Apple has the highest annual revenue and all the other companies are nowhere close in terms of sales. In terms of gross profit, Facebook enjoys the highest gross margins primarily driven by their social media advertising business. Source: Statista In terms of sales, Alphabet ranks second highest with above median gross profit margin percentages. In comparison to companies in ad business like Facebook, Twitter, Baidu, Yahoo, and Yandex. In the United States, the closest competitor to Alphabet in terms of sales is Facebook but its sales are almost 30% of Alphabet s revenue. Alphabet faces intense competition from Baidu and Yandex that are dominating the markets in China and Russia respectively making it difficult for Alphabet to acquire market share. The chart above shows that of all the social media applications in U.S., Facebook and YouTube had the Page 9

10 140.00x x x Forward P/E Comparisons x because it has very less hardware sales whereas companies like Microsoft, Apple and Alphabet has substantial hardware sales. This proves that Alphabet is a company with one of the premium EBIT and EBITDA margins x 60.00x 40.00x 20.00x 0.00x 37.58x 33.8x 32.97x 24.24x 17.75x 10.66x Source: Sentieo Edge Equity Terminal 54.89x 40.07x 12.43x From the chart above, we can see the forward P/E ratios of companies like Twitter, Yandex an Baidu are overvalued that indicates that a positive outlook for the online search and advertising industry and its end market demand drivers. ECONOMIC OUTLOOK We have a positive fundamental outlook for the Internet Software & Services sub industry. The companies in this industry have had good growth and posted healthy earnings in last few years and we expect it to continue in future. There is a strong correlation between growth of this industry and global employment growth. So, it is extremely necessary to forecast the US employment rate. It is also important to track the GDP growth forecasts for US as it revenue growth depends on the GDP growth. Ultimately, interest expense will form a bigger component due to long-term debt on Alphabet s Balance sheet. This is highly dependent on Fed Fund rates, we should forecast and estimate the rise in interest rates for coming years. GDP Growth Source: Tradingeconomics.com Source: Sentieo Edge Equity Terminal The chart above reflects EBIT margins vs the adjusted EBITDA margins and it shows that Alphabet has strong EBIT and EBITDA margins after Facebook and almost at par with Microsoft and Apple. This reflects that the company has strong operational efficiency. to Facebook in terms of EBIT margins. Facebook has high EBIT and EBITDA margins Going forward, the Real US GDP will grow and is expected to remain stable at around 2.5% ( ) and this should translate to a steady demand for online advertising. GDP growth directly correlates to buying power and disposable income available to spend on the advertisement expenses and technology such as smartphones, tablets, PCs, and other electronic devices. Page 10

11 Strengthening Dollar Stronger dollar is likely to put downward pressure on US exports. Alphabet is strongly dependent on revenue contributions from international sales. In 2016, almost 53% of revenue is generated outside USA. These international sales are highly sensitive to currency fluctuations. With new pro-business policies coming up, Henry Fund team forecasts that US Dollar will continue to strengthen. In next 2 years, we expect US$ per Euro to increase and is likely to have a negative impact revenues of software companies. Usually firms in this industry hedge against currency foreign currency receivables to minimize the risk of currency fluctuations. Graph suggests that the unemployment rates in United States has been all time low recently. The unemployment rate in the US has continued to decline. Current unemployment rate is 4.2% in Sep 2017 and the Henry Fund team believes that unemployment will reach 4.3% over next 6 months. This rising employment rates indicate positive impacts on Google s revenue. A good employment rate is positively correlated to spending on marketing and advertisement as well. A low unemployment rate also makes it more difficult to hire workers which pushes up wages. Google already faces challenges with hiring people in US who need special work visas. FED Interest rates Source: Tradingeconomics.com Federal Reserve Bank raised FED Funds rate in May 2017 to 1.16% and left the door open for further rates hikes. We forecast the fed funds rate will reach 2% over the 2 years horizon, while we estimate it to remain stable at 1.7% over the next six months. The increase will lead to increased borrowing costs which means that Alphabet will pay higher interest expense on the long-term debt. The table below depicts interest rate trends. Unemployment rate A good employment rate and low unemployment rate are good signs for Alphabet. As the employment increases, the disposable income available for spending on online advertisements, android applications, and electronics increases. Source: Macrotrends.net GOOGL s Balance sheet represent long-term debt of around $ 3.9 billion. As markets increases the interest rates in response to increase in Fed Funds rate, Google will have to pay more interest on this loan. Source: Page 11

12 INVESTMENT POSITIVES Based on our analysis, we project that as the number of online users and usage will increase, digital ad spending will increase too and Alphabet, being the market leader, will be the main beneficiary. Due to changing trends, as search traffic transforms from desktop platforms to mobile platforms, Alphabet will continue to generate top-line growth due to dominant market share of Android. We expect the revenues will rise 17% in 2017 and 2018 primarily driven by pricing improvements with opportunities related to mobile, video (YouTube, in particular) and cloud, and related improving pricing trends and increasing user engagement across display offerings, specially YouTube. This will be supported by strong management leadership. Alphabet continues to focus on long-term and sustainable growth opportunities by investing in innovation and research and development activities due to significant cash flow from the Google search business. INVESTMENT NEGATIVES Alphabet is investing heavily in capex towards high-risk projects and bets which may or may not generate revenues ever. There is no diversification in the revenue stream for Alphabet as more than 99% of revenue for Alphabet comes from advertising that ultimately depends on search ad space. Alphabet is facing intense competition in digital advertising space from companies like Facebook which are using the same techniques as Google to acquire the market share. This could harm Google s dominant position in this business and pressurize the operating margins. Strengthening U.S. dollar can have a negative impact the top-line growth for the company as more than 50% revenue is earned outside US. VALUATION price of $1185 and $861 respectively. We could not use Dividend Discount Model for our analysis because Alphabet Inc. has never declared dividend in the past since inception and do not plan to do so. The company believes in retention of earnings. Dividend payments are extremely costly for the company in a growing and evolving market which is one of the reason behind no dividend policy by Alphabet Inc. 1,400 1,200 1, Alphabet Share Price (USD) 1,034 Current Share Price 1,185 DCF Share price Source: Sentio(10) and HF Estimates 861 Relative P/E We believe the stock value is most closely captured by the DCF valuation as it most closely captures the revenue decomposition and growth forecasts of the different lines of business. Hence, we have given a BUY rating to the stock. The stock currently trades for around $1034 and thus we estimate a high upside of 14.6% P/E Trends-Relative Valuation Google follows a 52-week fiscal year ending in December. Discounted Cash Flow and relative P/E analysis have been used to value Google. The two approaches presented a Source: Sentio (10) P/E 17 P/E 18 Page 12

13 We also used relative P/E valuation technique which presented a price of $861. We compared Google to different online advertising and technology companies such as Facebook, Microsoft, Apple, Baidu, Twitter and a few others. That can be called as the closest competitors to Google. But there are differences in the business models and size of the clients. Due to different revenue segments and earnings composition, it is difficult to make a head to head comparison of these peer companies. Also, relative P/E valuation method assumes that market values peer stocks accurately. But these technology companies tend to have higher P/E multiples. This is because in the case of tech companies, the assumption is a growing stream of future income which increases the present value (share price) even though the present earnings are low. All these shortcomings of Relative P/E valuation method and non -applicability of DDM, leads us to believe that DCF valuation captures the stock value most accurately. Short-Term Revenue Growth Assumptions Advertising and licensing revenue is the biggest source of income for Alphabet Inc. as it has earned 99% of total revenue from advertising in This revenue is expected to grow in next 5 years as the number of users continues to increase. Paid clicks revenue is directly proportional to the engagement by users and clicks by end-users on advertisements related to searches on Google.com, and other apps such as Gmail, Maps, Google Play, and YouTube engagement. We expect this revenue from Google website to grow at a rate of 20% in and stabilize at 15% 2020 onwards. Revenue from Google Network Members properties revenues that consist primarily of advertising revenues generated from placing ads on Google Network Members properties expected to grow at a rate of 13% in and stabilize at 10%, 2020 onwards. Finally, we expect the revenue from Other Bets to grow at a healthy rate of 20% in and stabilize at 15% 2020 onwards. All the segments ensure sustainable revenue growth for Alphabet Inc. but we also need to consider the increased growth in other costs which grow in proportion with revenue such as cost of revenue - 39%, research and development - 15%, marketing expenses - 12% and general and administrative expenses -8% of sales. Other expenses like depreciation and amortization are expected to be 7% of beginning assets, respectively. Gross profit / Operating profit margins Cost of revenue used to calculate gross margin generally includes expenses related to the operation of data centers, such as facility and server equipment depreciation, salaries, benefits, and share-based compensation for employees on the operations teams, and energy and bandwidth costs. Historical data shows that Gross profit margin for Alphabet on an average has been 61% and net operating margin around 21%. We do not see any good and firm reason for these margins to change and so we forecasted gross profit margin to be 61% and net operating margin to be 20% for forecasted years. Capital Expenditure Based on historical average of amount spent on Property, Plant and equipment, we expect gross tangible assets to grow at 18% every year as we see as they fund the expansion of data center capacity and office facilities to support the continued rapid growth of the business. We expect this to grow at stable growth rate of 18% in forecasted period. In case of intangibles, gross intangibles fell by 27% in 2016 from 2015 but because company has acquired users, technology and patents in the past, and we assume that no big acquisition in next five years and hence, intangibles grow at a low rate of 7% for patents relating to new technological developments. Debt Alphabet currently has 3.9bn long-term debt on its Balance sheet for FY 2016 and as per the repayment schedule, will be paying around $525m every year for the forecasted period. We have assumed that company does not take any more debt. The company has operating leases and we have capitalized next 5-year lease payments in our model. Other assumptions We have assumed Beta as 0.98, based on data available on Yahoo Finance. Continuing value growth of EPS is assumed to be in line with estimated GDP growth i.e. estimated 3.5%. (11) Risk-free rate is taken as 2.88%, which is the 30-yr. treasury yield rate. Ultimately, we believe that the Equity Risk Premium is 4.8% which adequately captures the risk Page 13

14 associated with the market over and above the risk-free rate. Valuation Summary The DCF model presents a stock price of $1185, which represents 18% upside. The various sensitivity analyses performed have been conducted that reveal the target price for Alphabet share to be between $ $1300. The model also presents 14.6% upside potential over current market price which is driving the BUY recommendation for the stock. KEYS TO MONITOR Competition: Alphabet is facing a lot of competition from Facebook in the online advertising business. The top line revenue growth has been slowing down due to the increased competition from Facebook. We must keep a check on the rate at which the revenue from advertisements is declining. Law Suits: Alphabet has been fined $2.7 billion by the European Commission for antitrust violations pertaining to Google s Shopping search comparison service (8). Alleging that Google has systematically given prominent placement to its own comparison shopping service and has demoted rival comparison shopping services in its search results. This is one of the biggest law suit and any further lawsuits will impact the future earnings potential of Alphabet. Profit Margins: Alphabet historical operating margins (between 35% and 45%) and net margins (between 25% and 35%) have been quite stable. But if the company decides to spend a lot on increasing its Internet search offerings or diversify in new businesses, these margins could be adversely affected. Ad blockers: Software such as Ad Block Plus are working on features like whitelisting of ads, called acceptable ads list. These features would need to be monitored closely as any adverse developments could lead to significant adjustments to the revenue forecasts of Alphabet. 2. Wikipedia 3. Word stream e-advertising-statistics 4. Wordstream ow-much-does-adwords-cost 5. Statista 6. Internet World Stats 7. Seeking Alpha 8. TechCrunch 9. Quora Sentio &ads_add= &utm_campaign=&ut m_source=google&utm_medium=cpc&utm_term=sen tio&ads_network=g&placement=&gclid=cj0kcqjw1jb PBRCrARIsAOKj2Pm- 8dAizU7gqfxWs0P1PCHxkSEDQca6arJ4Vz9tZrRgWcZKa 93dTqAaAgfZEALw_wcB 11. World Bank 1. Alphabet 10-K REFERENCES 12. Tradingeconomics.com Page 14

15 13. Macrotrends.net Recode included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. e-ad-spending-growth-worldwide 15. Digiday Emarketer Video-Ad-Spending-Shows-Sharp-Increase/ Morningstar Equity Analyst Report 18. S&P Global Stock Report 19. Bank of America Equity report 20. Skyhigh Networks SmartInsights.com IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures Page 15

16 Alphabet Inc Key Assumptions of Valuation Model All figures are in millions Ticker Symbol (Class A) GOOGL Current Share Price $1, Ticker Symbol (Class C) GOOG Current Share Price $ Current Model Date 10/10/2017 Fiscal Year End Dec. 31 Pre-Tax Cost of Debt 3.45% Beta 0.98 Risk-Free Rate 2.88% Equity Risk Premium 5% CV Growth of NOPLAT 3.50% CV Growth of EPS 0 Current Dividend Yield 0.00% Operating cash assumption 2.00% Marginal Tax Rate 25.57% WACC ( ) 7.51% WACC ( ) 7.49% WACC(2021) 7.47% Total Shares outstanding( Class C) Total Shares outstanding (Class A) Total Shares outstanding (Class B) Dividend growth Rate 0% DCF Share price $1,185 Upside potential 14.66% 5 Yr CAGR Revenue Growth 15.55% 1Yr Treasury 1.42% Credit rating AA2

17 Alphabet Inc Sensitivity Analysis Beta % % % % Equity Risk 4.80% Premium 4.90% % % % % % % WACC - CV % 5.97% 6.47% 6.97% 7.47% 7.97% 8.47% 8.97% 9.47% 9.97% 10.47% 0.00% % % % CV NOPLAT 2.00% Growth 2.50% % % % % % Pre-Tax Cost of Debt % 2.25% 2.55% 2.85% 3.15% 3.45% 3.75% 4.05% 4.35% 4.65% 4.95% 1.88% % % % % Risk Free Rate 2.88% % % % % % % % % %

18 Research & Development General & administrative Cost of Revenue % 35.28% 36.28% 37.28% 38.28% 39.28% 40.28% 41.28% 42.28% 43.28% 44.28% 8.45% % % % % % % % % % % % % % % % Sales & marketing expenses % 7.61% 8.61% 9.61% 10.61% 11.61% 12.61% 13.61% 14.61% 15.61% 16.61% 0.74% % % % % % % % % % % % % % % %

19 Alphabet Inc Revenue Decomposition All figures are in millions Fiscal Years Ending Dec E 2018E 2019E 2020E 2021E Google (advertising & other) 66,001 74,541 89, , , , , ,162 Other Bets revenues ,165 1,375 1,581 1,818 Motorola Mobile (hardware & other) Revenues 66,001 74,989 90, , , , , ,980 % Google (advertising & other) 100% 99% 99% 99% 99% 99% 99% 99% % Other Bets 0% 1% 1% 1% 1% 1% 1% 1% % Motorola 0% 0% 0% 0% 0% 0% 0% 0% % Total Revenue 100% 100% 100% 100% 100% 100% 100% 100% Advertising Growth Rate 19% 13% 20% 17% 17% 16% 13% 13% Other Bets Growth Rate NA NA 81% 20% 20% 18% 15% 15% Motorola Growth Rate -100% NA NA NA NA NA NA NA Total Revenue Growth Rate 10% 14% 20% 17% 17% 16% 13% 13% Google Segment Revenue Breakdown Google Websites 45,085 52,357 63,785 76,542 91, , , ,945 Network Members's Websites 13,971 15,033 15,598 17,626 19,917 22,506 24,757 27,233 Other Revenues 6,945 7,151 10,080 10,685 11,326 12,005 12,486 12,985 Total Revenue from Google Segmen 66,001 74,541 89, , , , , ,162 % Google Websites 68% 70% 71% 71% 71% 71% 71% 71% % Network Members's Websites 21% 20% 17% 17% 17% 17% 17% 17% % Other Revenues 11% 10% 11% 11% 11% 11% 11% 11% Google Websites Growth 20% 16% 22% 20% 20% 19% 15% 15% Network Members's Websites Grow 6% 8% 4% 13% 13% 13% 10% 10% Other Revenues Growth 40% 3% 41% 6% 6% 6% 4% 4% Rest of the World % 45% 44% 44% 44% 44% 44% 44% 44% UK Revenue % 10% 10% 9% 9% 9% 9% 9% 9% Domestic Revenue % 45% 46% 47% 47% 47% 47% 47% 47%

20 Alphabet Inc Income Statement All figures are in millions Fiscal Years Ending Dec E 2018E 2019E 2020E 2021E Google (advertising & other) 66,001 74,541 89, , , , , ,162 Other Bets revenues ,165 1,375 1,581 1,818 Motorola Mobile (hardware & other) Revenues 66,001 74,989 90, , , , , ,980 Cost of revenues - Google (advertising & other) 25,691 28,164 35,138 41,564 48,804 56,845 64,411 73,047 Cost of revenues 25,691 28,164 35,138 41,564 48,804 56,845 64,411 73,047 Gross Profit 40,310 46,825 55,134 64,260 75,454 87,884 99, ,934 Research & development expenses 9,832 12,282 13,948 16,351 19,199 22,362 25,339 28,736 Sales & marketing expenses 8,131 9,047 10,485 12,291 14,432 16,810 19,048 21,601 General & administrative expenses 5,851 6,136 6,985 8,188 9,615 11,199 12,689 14,391 Charge related to thr resolution of Department of Justice Operating Costs and Expenses 23,814 27,465 31,418 36,830 43,247 50,371 57,075 64,728 Income from operations 16,496 19,360 23,716 27,429 32,207 37,513 42,506 48,206 Impairment of equity investments Interest income (expense) & other, net ,006 1,040 Income from continuing operations before income tax 17,259 19,651 24,150 28,336 33,147 38,486 43,513 49,245 Provision for income taxes 3,331 3,303 4,672 7,246 8,476 9,841 11,127 12,592 Net income from continuing operations 13,928 16,348 19,478 21,090 24,671 28,645 32,386 36,653 Net income (loss) from discontinued operations Net income 14,444 16,348 19,478 21,090 24,671 28,645 32,386 36,653 Year end shares outstanding Net income (loss) per share - basic Dividends per share

21 Alphabet Inc Balance Sheet All figures are in millions Fiscal Years Ending Dec E 2018E 2019E 2020E 2021E ASSETS: Cash & cash equivalents 18,347 16,549 12,918 24,630 36,416 50,658 66,682 84,994 Marketable securities 46,048 56,517 73,415 74,457 75,515 76,587 77,675 78,778 Total cash, cash equivalents, & marketable securities 64,395 73,066 86,333 99, , , , ,771 Accounts receivable, gross 9,608 11,852 14,604 17,120 20,102 23,414 26,530 30,087 Allowance Accounts receivable, net 9,383 11,556 14,137 16,572 19,459 22,665 25,682 29,125 Inventories Receivable under reverse repurchase agreements Deferred income taxes, net 1, Income taxes receivable, net 1,298 1, Prepaid revenue share, expenses & other assets 3,412 2,648 4,575 5,363 6,297 7,335 8,311 9,426 Total current assets 80,685 90, , , , , , ,322 Prepaid revenue share, expenses & other assets, non-current 3,280 3,181 1,819 2,132 2,504 2,916 3,304 3,748 Non-marketable investments 3,079 5,183 5,878 6,490 7,165 7,911 8,735 9,644 Deferred income taxes Property & equipment, gross 32,746 40,146 47,527 56,265 66,610 78,856 93, ,517 Less: accumulated depreciation & amortization 8,863 11,130 13,293 15,614 18,370 21,641 25,520 30,119 Property & equipment, net 23,883 29,016 34,234 40,651 48,239 57,215 67,834 80,398 Intangible assets, Gross 8,730 6,357 6,802 7,278 7,788 8,333 8,916 Accumulated Amortization 4,883 3,050 3,814 4,499 5,078 5,565 6,025 Intangible assets, net 4,607 3,847 3,307 2,988 2,779 2,710 2,768 2,891 Goodwill 15,599 15,869 16,468 17,090 17,735 18,404 19,099 19,820 Total assets 131, , , , , , , ,320