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Alphabet’s Growth Profile Remains Strong

After reaching all-time highs in April, Alphabet Inc. (Nasdaq: GOOG and GOOGL) shares have been weak after reporting disappointing first quarter 2019 results. In addition to unfavorable currency movement, slowing sales growth, and higher operating costs, investors are grappling with the lack of management disclosure to pinpoint which parts of the business are not performing as expected. Even so, Alphabet’s growth profile remains strong and the current price represents a reasonable entry point for long-term investors, Doug Gerlach, Editor, Investor Advisory Service,

“The foundation of Alphabet is online advertising, which grew 15% in the first quarter and represents 85% of total sales. Within advertising, the company breaks down its results into two segments: Google Sites and Network, which make up 84% and 16% of advertising sales, respectively. Google Sites represents properties directly owned by Alphabet including search, both mobile and desktop, and video site YouTube. The continued growth of YouTube and mobile computing is fueling rapid volume growth on Google Sites as paid clicks grew 39% in the first quarter. However, this growth falls far short of 2018’s gain of 62%. Management explained that much of the slowdown is due to changes YouTube made in early 2018 to enhance the user and advertising experience. Slightly offsetting this slowdown is a slower rate of decline in cost-per-click, which fell 19% in the first quarter versus 25% for all of 2018.

The Network segment includes websites that use Alphabet technology to implement online advertising. An example is an online news site that serves up display ads. Impressions and cost per impression grew 6% and 1%, respectively, in the first quarter.

One area of concern for advertising margins is the cost of acquiring display inventory and access, which the company calls Traffic Acquisition Cost (TAC). After increasing faster than sales over the past few years, Alphabet expects these costs to moderate as they did in the first quarter, declining from 24% of Google’s advertising revenue to 22%. Much of this decline is coming from the Network segment, offset somewhat by TAC for Google Sites to access mobile users, such as those on the Apple iPhone.

Even with slowing results, YouTube is an asset with great potential for further monetization. Management does not break out metrics, but according to Omnicore, a digital and marketing agency, YouTube has 1.9 billion monthly active users watching 5 billion videos per day. YouTube services 88 countries in 76 languages representing about 95% of all internet users. As customers continue to cut the cord on cable and reduce television viewing, YouTube has great potential to charge for content. YouTube TV, a recently introduced paid subscription service, has 300,000 customers, a small fraction of its potential.

The Google Other segment grew 25% in the first quarter and made up about 15% of sales. This segment includes Cloud computing, Play marketplace, and hardware (Nest smart home devices, Pixel smartphone, Chromebooks, and Home Assistant devices). Of these three businesses, hardware generates the lowest margins, but Alphabet feels it needs to make devices that support its Android mobile operating system. The Play marketplace supports downloadable media for its Android user base, and the company gets a cut of roughly 30% of every dollar of purchases.

Alphabet’s Cloud service provides outsourced data center hosting for corporate customers. While the service is #3 in its industry, behind Amazon and Microsoft, it grew 94% in 2018 according to Canalys Research. The market for Cloud services is growing rapidly and has many years to run. According to Crisp Vendor Universe, only 20% of businesses have transitioned any of their IT to the Cloud.

The remaining growth opportunities for Alphabet are contained within its Other Bets segment that makes up less than 1% of sales but had a loss of $3.4 billion in 2018. This is a collection of incubator ideas that may never amount to much. However, one that could hold great potential is Waymo, the firm’s self-driving vehicle project. Waymo has impressive statistics, including 10 million self-driven miles across 25 different U.S. cities, far more than other self-driving competitors.

A significant risk for Alphabet involves government regulation and fines for violations. Europe has fined Alphabet three times in the past two-plus years, the most recent a $1.7 billion first quarter charge for infringement of European competition law. Governments also seem set to create regulations to protect user privacy in the face of alleged violations from social media firm Facebook and others.

Analysts expect Alphabet to grow EPS at an average annual rate of 16%. We are slightly more conservative and will project 15%. Five years of 15% EPS growth multiplied by a high P/E of 30.5 generates a potential high price of 2593. If achieved, this would represent annual compound growth of 18% for the shares. We utilize the recent severe low price of 772 as the stock’s floor. This represents a possible loss of 32% from the current price. We model the upside/downside ratio as 4.1 to 1.

Editor’s Note: Alphabet Inc. is listed on the Nasdaq under the symbols GOOG and GOOGL. The difference is that GOOG shares are non-voting Class C stock and GOOGL shares are voting Class A stock. The non-voting GOOG shares typically trade at a small discount to the voting GOOGL shares.

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