• Commentary on Alphabet's Q1 2018 results is focusing on decreasing margins and the whooping $7.2 billion capital expenditures.

• Indeed, Google is investing aggressively in Cloud and Hardware, which shows on both operating and capital expenditures.

• We adjust reported financials for investments in growth and show that growth in earnings power actually outpaced growth in revenues.

• We share our estimation of Earnings Power Value and argue that at $1000/share and with exceptional avenues of value-accretive growth, the long opportunity is compelling.

Q1 2018 results show accelerating earnings growth

For Q1 2018, Alphabet (GOOG, GOOGL) reported 23% YoY constant-currency revenue growth, the fastest since 2014. Reported operating income growth came in at a modest 6.6%, with 500 bps of operating margin compression from 27% to 22%.

But that's just reported GAAP numbers.

The implementation of the new accounting standard ASU 2016-01, that changes the accounting rules for equity security investments (such as Alphabet's investment in Uber), increased reported operating expenses by $632 million. Adjusting for this non-cash charge brings operating income to $7,633 million, for 16.2% YoY growth and 24.5% operating margins. Still a hit, but much milder.

We also think that a significant part of Alphabet's reported expenditures should be seen as investments rather than expenses. In particular, we note that reported R&D and S&M expenses increased 28% and 36% YoY, significantly outpacing top-line expansion, as Alphabet hired aggressively to build its Cloud and Hardware teams (the HTC team was incorporated this quarter).

Had R&D and S&M expenses grown in line with revenues, adjusted operating income would have come in at $8,175 million, for 24.5% YoY growth and 26% operating margin.That is, a 100 bps margin compression, but with operating income growth outpacing (constant-currency) top-line growth!

Contrary to the prevailing market sentiment, we believe that Alphabet's economic earnings growth is actually accelerating.

Increasing traffic acquisition costs (TAC) paid to companies like Apple (AAPL) are being more than offset by operating leverage, after accounting for investments in growth. And the acceleration in earnings growth is likely to continue as TAC growth moderates in the coming quarters, according to management commentary.

Alphabet is investing aggressively in Cloud, AI and Hardware

Q1 2018 capital expenditures were a whooping $7.3 billion, worlds away from the $2.5 billion in the same quarter last year or the $2.0 billion of depreciation and amortization charges. Even after adjusting for the (hopefully) one-off $2.4 billion acquisition of Manhattan's Chelsea Market building, capex roughly doubled YoY.

But it should come as no surprise. Alphabet wants to build on its search and advertising leadership and become a diversified technological giant, and this level of investment only confirms their commitment. Most of the investment will be going towards CPUs, GPUs, memory and network assets for data center infrastructure.

As an aside: Nvidia (NVDA), Intel (INTC) and Micron (MU) investors should be rubbing hands. Amazon's (AMZN) should accept the inevitable: exceptional rates of return attract ravenous competition. Yesterday, it was Microsoft (MSFT). Tomorrow, it will be Google too. The cloud market is huge and growing, but AWS margins may not stay above 20% for long (despite their head start, we don't believe Amazon has any IT know-how that Google won't be able to replicate).

We are less excited about Alphabet's renewed push into Hardware. We think it is the right move to protect the Android/Chrome/Search ecosystem, and keep TAC under control, but we don't expect positive direct value contribution anytime soon --if ever. In the 2020s, device profits will continue belonging to Apple.

That said, we see Search having a decade+ of double-digit growth ahead, YouTube in the early innings of monetization and possibly worth north of $100 billion as a stand-alone business, and Waymo among the best positioned to capitalize on the mass market adoption of autonomous transportation systems.

We believe that there is an economic case for the diversification. Across the avenues of growth run the common threads of complex software systems and AI, of which Google is arguably a leader and pioneer.

Valuation, takeaways and future work

At $1000/share, we estimate that Alphabet is trading at about 1.25x Earnings Power Value (ex-cash and without "Other Bets"), that is, at a 25% premium of the net present value of the cash flows to shareholders, had management decided to stop investments in growth and distribute all FCF.

But management is investing in growth (aggressively), and given that most investment is being directed to areas adjacent to the core business and where Google's AI-expertise provides competitive advantages, that growth is very likely to generate significant shareholder value.

Hence we see the $1000/share price as very compelling. So compelling that it raises the question of how the market is missing it.

But this sort of mispricings occur quite often. Remember Apple in August 2015 at $90/share? After less than 3 years, it is at $163, and it is not overvalued. The fundamentals are the same, it is the market appraisal that has changed.

This time, investor sentiment has turned negative on Google (regulatory risks, competitive threats, uncontrolled TAC) just as the company invests aggressively in its "second wave of growth" (YouTube, hardware, and cloud). And on its third wave (Waymo and AI applications to healthcare). And on many other things (Assistant, IoT, payments, maps, Chrome, and Android, to name a few).

Temporal pessimism in the markets + strategical changes in the company, does it sound familiar? It is the environment in which investors like Warren Buffet have made their fortunes.

Call it short-termism. Or herd behavior. Or just opportunity.

As for us, we may initiate a long position in the coming days. It would complement our market-beating portfolio rather nicely.

With Nvidia and Google, we own the future of AI. With Tesla (TSLA) and Waymo, autonomous transportation. With Apple and Google, mobile. With The Trade Desk (TTD) and Google, digital advertising, inside and outside the big walled garden.

The owners of 4 enormous, inevitable, secular trends. In a portfolio of just 12 positions, all positions initiated opportunistically, at prices well below intrinsic value.

Feel free to join for the ride.