WORLD-LEADING CORPORATES CONTINUALLY SURPRISE US. IN ORDER TO STAY IN THE ELITE THEY COMMUNICATE MORE AND MORE VISIONARY IDEAS. THEIR MARKET CAPITALIZATION IS LARGELY IMPACTED BY THE PERCEIVED SCOPE AND GROWTH OF FUTURE OPERATIONS, SO THE MORE ABSTRACT & DARING THEY ARE, THE MORE INTEREST THEY RAISE AND HIGHER IS THEIR POTENTIAL. THE WINNERS ARE THOSE WHO RISK A LOT, BUT IN A SMART WAY – CASE OF ALPHABET INC.

Alphabet Inc. is a financial holding, the epicenter of creativity and innovation of incredible scope. Google Inc. currently represents the majority of this holding, while other companies are still in relatively early phases of their development. These are Access, Calico, CapitalG, GV, Nest, Verily, Waymo, X and many other projects, which are about to be spin-offs / carve-outs in the near future. The activity focus is on information organization, investment banking, IT infrastructure, biology and aging, healthcare, home management, transport and logistics, television etc.

Already the name (Alphabet Inc.) symbolizes the organization’s mission, placement of so called »alpha bets«. Albert Einstein once said: »The best investment is investment in one’s knowledge.« and it seems that Alphabet Inc. took this statement seriously. They bet more and more intensively on the combination of technology and learning – machine learning and artificial intelligence.

The potential of these two technologies can be well understood from a simple chess experiment. The computer was given the game instructions and develop its own knowledge of playing based on own iterations. In less than 4h of playing the cumulative knowledge already exceeded the amount of cumulative chess knowledge developed by people through centuries of playing this game. Chess is only one of the examples, in reality there are numerous potential applications. Speaking from the monetary perspective, the value of the market is estimated in trillions of US dollars. The two technologies may result in a double digit GDP growth of the world.

We are probably not even aware of the progress that is about to be made in next years. The cumulative knowledge base will get new dimensions, since the knowledge begins to grow at significantly faster pace. Practically, in line with the IT infrastructure development. Inventions such as Quantum computers, however, will speed things up. New knowledge will open the door to a world of completely different life.

A well-known Chinese magnate and businessman, Jack Ma, at one of the public speeches said: “It is more important that you are the first one, than that you do things perfectly.” With this statement he highlights the importance of the »first mover effect«, the entrepreneurs are still under-aware. Not only that Alphabet Inc. is normally among the ground-beakers, its innovation in combination with market dominance actively address also the so-called »trend setting«.

If so far Google Search was considered as the leading tool for searching information on computers, phones, tablets and other media; the company is opening a new, even more promising chapter. With the integration of artificial intelligence and machine learning they a targeting a more strategic role in one’s life, becoming personal assistants. This will drastically improve the role Google Inc. plays in our lives and of course simplify our operationally challenging everyday. Despite the fact that Amazon’s Alexa and Apple’s Siri came first and were until recently leading by active users, it appears that the winner of this battle is going to be Google Inc., also due to the cross-product synergies.

Innovation is just a base. In order to make an idea a success story, much more is needed. Among others, also the ability of market penetration. Recall how Google Inc. in the past used not only organic approaches, but also corporate acquisitions to speed up the market integration at just the right time. Today, Android probably would not be so well-known and widely used if Motorola Mobility acquisition would not take place back then ($ 12.5 billion, 2012) and accelerate the penetration. The same applies to the acquisition of Nest Labs (USD 3.2 billion, 2014), which enabled the company to develop its presence in households in the IoT segment; and the acquisition of YouTube ($ 1.7 billion, 2006), which enabled Google Inc. to successfully responded to the transfer of traditional television to the world wide web and significantly increase its advertising potential. Mind also the takeover of the Israeli company Waze ($ 1.15 billion, 2013), which significantly improved the Google Maps with more advanced travel time calculation, suggesting the most optimal routes, etc .; or the acquisition of the HTC Pixel Smartphone Division ($ 1.1 billion, 2017), which strengthened the development team in some critical areas and may seriously jeopardize Apple’s Iphone profit cake. Advanced strategic management and bold thinking result in more than 200 other corporate acquisitions made in the last 10 years – Gradient Ventures and the Google Assistant Investment Program play an increasingly important role.

Alphabet Inc. understands very well how important it is to actively monitor and set trends. People’s habits are changing rapidly all the time, opening up new market opportunities. Being the first in key segments such as machine learning and artificial intelligence opens the door to the potential of enormous value generation in the future. Capital un-intensive business requires management to focus its efforts on growth – thus the tendency to focus on end users, user experience, brand perception, customer loyalty, customer satisfaction, etc.

Past financial figures confirm that the tactics is right. Past growth rates are high (Net sales CAGR2014-17: 18.9%; EBIT CAGR2014-17: 16.6%), which partly also reflects smart allocation of resources and the increasingly active penetration of emerging emerging markets such as India, South Asia, China and others.

Source: Alphabet Inc. Consilue analysis.

Despite impressive financial statements, many investors believe in hidden reserves. The complaints relate to the monetization of solutions, excessive share of more expensive equity in the financial structure, unnecessary exposure with short-term financial investments, etc. As a result, the capital market position of the company is not optimal. Measures of protection against hostile takeovers, such as, the issue of multi-class shares with different management rights, which give the founders the main managing role in the company, additionally worsen the situation.

Source: Alphabet Inc. Consilue analysis.

The chart above shows year-on-year increase in surplus cash »Money and short-term financial investments« (31 Dec 2017: USD 102 billion) and its financing. In other words, a substantial portion of equity is used to invest in US bonds and similar short-term liquid instruments. For some stupidity, for others a masterpiece. The fact is that it is very difficult to judge the situation on limited outer data. One of the theories that advocates the current management’s behavior is that the reasons for the significant surplus should be sought in the context of tax benefits. Companies like Alphabet Inc., Apple Inc., Microsoft Inc., Cisco Inc. and others hold a cumulative 0.5 trillion dollars of surplus cash in their balance sheets. Their bargaining power against the tax regulator is strengthening every year and call for a more favored one-time tax treatment, co called »tax holidays«. They wisely wait for the right moment to come. In times of crisis, the saying »Money is the king.« is well-known.

Critics respond with counter-arguments. One of them, for example, is that Google Inc. is with its balance sheet full of surplus funds becoming an important player in the world of investment banking, a world of sharks. Investor doubt in safety of these funds, due to the company mysterious behavior and (little) amount of attention.

From the value point of view, the lever of Alphabet Inc. (Google Inc.) is not really the amount of excess cash, but rather the ability to invest it in a very smart way. Not only within the technology sector, but also wider. The financial holding has a unique weapon in their hands – Google search queries. The latter can be demonstrated with, for example, comparing the number of Google search queries and the Bitcoin (BTC) price development. The correlation between one and the other is extremely high and, as in many other cases, provides a good basis for investment decision making.

Source: Alphabet Inc. Consilue analysis.

Corporate strategy – it is about our path. How we are achieving our goals. How wide and open we look at things. How capable we are to appropriately address macro trends. How we recognize and manage advantages, weaknesses, opportunities and dangers. How we strengthen purchasing power within the industry. How we make advantage of our corporate competences, competitive advantages, capabilities etc.

Google’s strategic management is in many views exceptional. Advanced future-thinking, technology, innovation and creativity. In everyday life, things are of course much more complex than the chess game, but something is certain. Development goes on with the speed of light. The ideas we have been acquainted with a decade ago in science fiction movies are now part of our everyday life. But ideas are not all, they are only the beginnings. Its the corporate strategy who decides whether they will play an active role in our lives or not. Corporates need to do unique, break-through things. Today we need to think about how the life will look in twenty years. We need to think about the virtual reality, personal assistants, gene modification, molecular designing, personalized medicine, (cell)growing of meat etc. Dare to risk, but in a smart way – just as the leading companies do.

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COMPANIES ARE CREATING VALUE FOR THEIR SHAREHOLDERS IN A MORE AND MORE ORIGINAL WAYS. THEY BET ON VARIOUS THINGS: INNOVATIVE BUSINESS MODELS, ECONOMIES OF SCALE, COMPETITIVE ADVANTAGES ETC. APPROACHES DIFFER AND SOME MAY EVEN LOOK STRANGE FOR THOSE THAT DO NOT REALLY HAVE A STRONG FINANCIAL BACKGROUND – CASE OF HOME DEPOT INC.

Company Home Depot Inc. is a US retail giant, selling equipment for home, garden and workshop. Their products and services are sold throughout the network of 2.200+ stores in USA, Canada, Mexico and online. The company is the biggest retailer worldwide in its segment. In financial year 2017 the company generated 101,0 billion USD net sales and 16,5 billion USD EBITDA. More than all non-financial legal entities in a smaller country such as Slovenia, EU.

Why is increasing the financial debt beneficial?

The company operates in a smart way. Part of the success story is linked also to the financial structure and its restructuring. In last years the company is increasing the level of financial debt and decreasing the level of equity. In this way Home Depot Inc. is increasing its Return on equity (ROE). Meaning, the shareholders’ equity is being managed in a more and more efficient way. Let’s look more in details how this is possible.

Development of invested capital and return on equity (ROE) of Home Depot Inc.

Source: Home Depot Inc. Consilue analysis.

Invested capital as at the end of FY 2017 amounts to 28,5 billion USD. Financial debt equals 27 billion USD and shareholder’s equity 1,5 billion USD. One can quickly notice that the indebtedness measured as D/E ratio is »very high«, 1611%. Nevertheless, the ratio as such is not really problematic. The key is to consider the market (not book value) indebtedness ratio. In the case of Home Depot Inc. future returns on invested capital are expected significantly above the weighted average cost of capital (WACC). The market value of equity therefore significantly (more than 100x) exceeds its book value, making the healthy debt levels significantly higher.

The more value the company creates, the higher the optimal levels of debt. As the debt levels built, the ease of creating value for shareholders increase. And the system works as a spiral. The more debt there is, the higher the value for shareholders.

Financial debt and debt management

Financing mix with a leverage as in the case of Home Depot Inc also brings challenges. A mistake in managing financing can have serious consequences. Financial debt can quickly show its other face. Proper supervision of risks and stabilization of future cash flow is therefore of crucial importance. Management of Home Depot Inc. is well aware of this fact. They are eager to continuously strengthen the underlying competences. Especially those that influence the increase in gross margin and further development of competitive advantages.

Financial debt is being managed carefully. Risks related to new obligations and danger of eventual liquidity gaps are continuously addressed in a proper way. The majority of debt is of long-term nature. Its maturities match the maturities of underlying projects. The company does not seek to create »fast« profits at the expense of differences in maturities. The company is aware of risks and the fact that this is not really their business.

Table of financial debt as at the end of FY 2017 (m’ USD):

Source: Home Depot Inc. Consilue analysis.

The financial structure is despite the relatively leveraged financial mix, stable. What makes it sustainable is the value that is being created. Additionally, the lenders are also well aware of the fact that the ratio Net debt / EBITDA as at the end of FY 2017 amounts to »only« 1,4x. This fact additionally strengthens the position of the company. It messages that in case of tightening, the financial debt can still be relatively quickly repaid with operational cash flow.

The success story described above still has space to develop further. The debt levels are not yet optimal, meaning that in the area of debt management there is still space for improvements and value creation. Yield to maturity for 10-year bonds is below 5,0%, meaning that eventual increase of debt levels is further improving the weighted average cost of capital.

The developments described are strongly appreciated by the investors. The value of the Home Depot Inc. stock in last 7 years strongly outperformed competitive peer companies. The growth was truly significant, from 30 USD/share to 200 USD/share. Furthermore, the company was also paying out dividends. Compounded annual growth rate (CAGR) of the Home Depot Inc. stock in the period that matches FY 2011 – FY 2017 amounts to 28,5%, compared to the 9,6% growth of S&P Retail index.

Chart: Stock price development

Source: Bloomberg. Consilue analysis.

As we see, the financial debt is taking the nature of equity. D.E.B.T. is the magic word or key to a success of Home Depot Inc. The more the indebtedness increases, the more the value increases. On the given case we see how event the financing structure can become the source of value creation for shareholders and even a strategic competitive advantage of a company.

Is value creation in your company addressed in a sufficiently advanced way? Do you know the specifics and best practices that would fit your company best? Does your strategy hide innovative financial & business approaches or you think it is just another block of paper in your drawer? Which strategic decision may hit your competitors next?

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Optimal capital structure (often also referred as or optimal financing mix) is one of the basic things required for a sound business. It refers to the way how companies finance their assets, how much it costs them and what they risk with it. Generally speaking, we talk about payables financing (suppliers), debt financing (banks) and equity financing (shareholders).

Corporate finance theory often addresses financing through weighted cost of capital (WACC), signaling the minimum level of return on assets engaged for which the economic value of the company is not being destroyed. For a perfect capital mix, the WACC is the lowest and the value for shareholders is maximized.

Financing mix: Balancing debt – equity

The chart presenting WACC in relation to the D/E ratio is U-shaped. Right part of the curve (area where the D/E ratio is above the optimal levels) is much steeper than the left part, signaling the fact that being too indebted is a bad decision to make.

The risk-taking of creditors is by its nature normally limited and therefore the financing is relatively attractively charged … at least as long the company indebtedness is in the healthy zone. When the company bridges that zone, the creditors start demanding higher collateral, decreasing the days of receivables outstanding, seeking to securitize receivables with third parties and increase the prices of goods sold, increasing the interest rates for refinancing activities etc. In this phase the company is already operating on the edge, risking increased illiquidity threats.

Optimal debt level is a relative term

Interestingly, levels of a sound financial debt globally significantly varies and is very much correlated with the 1) attractiveness of the region for the investors and investment flows as well as 2) growth potential. As expected, the highest debt levels are in developed countries such as USA and Western European countries (roughly 60% D/E ratio; 7x-8x Financial obligations / EBITDA ratio), followed by the developing Latin American countries, China, African & Middle East countries (roughly 50% D/E ratio; 6x-7x Financial obligations / EBITDA ratio) and relatively poorly indebted Eastern European countries and India (roughly 40% D/E ratio; 3x-4x Financial obligations / EBITDA ratio).

Almost half of the companies globally operate without or with minimal (<10%) financial debt and from that perspective do not exploit their full value maximization potential. On the other side, the debt of larger companies is often above the industry averages, transforming the debt into the strategical competitive advantage. In this context, we sometimes also see marginal leverage buyouts (LBOs) cases, that due to the leveraged nature and long-time periods often generate some value on the debt side.

Access to the right financial resources is crucial

Financing resources are the prerequisite for the company to operate as well as grow – organically (i.e. own investments in PPE) or inorganically (i.e. through M&A). When the company is growing at a fast pace and the business is either working capital intensive or PPE investment intensive, the company needs to be able to sufficiently provide new sources of equity as well. Generally acceptable is that the more mature the company is, the easier it is to find, maintain and optimize the financial resources. Companies in the early stages of development therefore often need to seek the seed and venture capital, since their risks are simply too high for the standard and risk-averse (not risk-loving) creditors. Furthermore, also companies in the early and mid-developing phase with high growth potential often come across liquidity problems, if they are not efficiently gathering their financial resources.

Equity financing is on one side most exposed to risks, but on the other side also unlimited upwards in terms of reward, since all the potential profits go to shareholders.

To sum up things, in terms of value for shareholders, a sound mix is preferable. Liabilities (payables financing & debt financing) help the company to exploit the full potential of value generation, while equity normally serves as a buffer.

Despite the fact that most successful companies in the last decade generated their value mostly through digitalization and non-asset intensive growth, the financing structure overall is not losing on its importance. Quite opposite, the market is becoming more competitive, leaving less & less space for errors and non-optimal financing structure.

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