All three companies reported stellar earnings, blowing past estimates and laying out exciting plans for the future. All three are cloud infrastructure providers, although that’s not their bread and butter (yet). All operate on a huge scale across the world and all are growth oriented (so in investment mode and no dividends).
But there are some big differences too: Amazon AMZN stands out because it’s mainly a retail company. Alphabet GOOGL and Microsoft MSFT are both technology companies, but one drives most of its revenue from effective content distribution on its software platform, while the other directly licenses/sells its software, increasingly, as a service.
So after the solid earnings reports and positive estimate revisions, one might wonder which one to invest in. The following metrics might help take a decision:
Revenue Growth
While all the companies have grown revenue over the last few years, Amazon’s growth has been truly meteoric as it clocked huge sales mainly in retail (taking share from rivals) but also in technology (being a first mover in infrastructure as a service, or IaaS).
Microsoft’s graph illustrates the company’s ongoing transformation from an old tech company to a new age one. Its enterprise licenses ensured that a lot of revenue was annuity-based. But Microsoft is building momentum around its Office 365, Dynamics 365 and Windows as a service offerings, so even more of its revenue should become annuity based. In the interim, revenue growth can appear to flatten out as some revenue that was earlier recognized upfront is now deferred.
In Alphabet’s case, revenue growth has been consistent because of Google’s dominance in search and the fact that its “Other Bets” are still a very small part of the business
Operating Expense Control
Amazon’s revenues are coming at a huge cost to the company mainly because of rising technology and content costs as the company tries to eat into the market that Netflix created.
Microsoft, on the other hand, saw a spike in opex because of its ill-advised acquisition of Nokia’s hardware business. But the company has exercised very good discipline over the years as far as cost is concerned. Also, its geographical breadth and the fact that already offered some enterprise software in what is today called the cloud meant that Microsoft has had to spend relatively less than the others on its IaaS rollout.
Most of Alphabet’s cost increase comes in R&D although marketing costs have also risen as it repositioned its brand as Alphabet and started selling an increasing amount of hardware. It has been very disciplined about G&A.
Earnings Growth
Amazon’s earnings have seen several ups and downs depending upon its need to build fulfillment centers, costs to finance its warehouses for fulfillment by Amazon (FBA) services and infrastructure buildouts for AWS, or its need to provide for taxes (Sep and Mar are usually down quarters for taxes). Share count increases have been more or less consistent.
In Microsoft’s case, earnings fluctuations are driven by taxes but non-operating income also influences the number. The share count has declined steadily over the years indicating that it has been one of the factors helping earnings growth.
Alphabet’s earnings picture is similar to Microsoft’s. The share count has also declined steadily, so like Microsoft, it has been one of the factors helping earnings growth.
Free Cash Flow (Cash Flow Less Capex)
Retail is typically a lower-margin business than technology and Amazon’s margin is the lowest of the low because it prices aggressively to capture ever growing market share. AWS is far more profitable for the company, but requires significant investment at this point. So Amazon’s FCF growth isn’t too exciting.
Microsoft’s cash cow was Windows, the operating system used by most PCs in the past. Today there are other options, but Windows still commands a dominant share. Microsoft is even more strongly positioned in productivity software (Office) and has leveraged this strength in its shift to a cloud-based model. Its R&D prowess and enterprise relationships are further supporting this move. So cash flow should remain strong.
Alphabet owns the dominant search engine all over the world that it continues to improve to date. In recent years, its YouTube platform has also been growing very fast. The company’s core business is not threatened by the growing competition from Facebook FB, Amazon and others for advertising revenue, but it has several interesting diversification plans such as self-driving cars, Fiber, Internet-beaming balloons, Calico, Sidwalk Labs, etc that can transform it into quite the conglomerate. Alphabet brought in Ruth Porat to introduce cost discipline given the many projects it is in and the result has been good thus far. So cash flow, while not as robust as Microsoft, should remain strong and growing.
Valuation
The following valuation is on the basis of price to free cash flow and price to sales.
Amazon is undervalued with respect to the S&P 500 on a P/S basis but overvalued on the basis P/FCF.
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Microsoft is undervalued on the basis of P/FCF but overvalued on the basis of P/S.
Alphabet is slightly undervalued on the basis of P/CF and but it is overvalued on the basis of P/S.
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Conclusion
While all the companies offer strong growth, Microsoft is particularly attractive on the basis of its cash flows. That’s why it’s the choice with the lowest risk. Amazon generates strong revenue but it’s making huge investments that aren’t yet translating to solid cash flows. So there’s more risk involved. Alphabet is a stock we should probably hold on to because it is relatively less attractive than the others.
You can also the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
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