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Morningstar | Alphabet’s Ad Revenue Growth Continues to Impress; Maintaining $1,300 FVE; Shares Undervalued. See Updated Analyst Note from 04 Feb 2019

Alphabet reported better-than-expected fourth-quarter revenue as the firm continues to grow its advertising business impressively. With GDPR, and data security and privacy issues surrounding the firm and its online advertising peers, Alphabet, similar to Facebook, continues to monetize its users and attract more ad dollars to not only its search but also its YouTube video platform. In our view, this demonstrates the firm’s strong network effect moat source. While Alphabet’s operating margin was in line with our internal projection, it was slightly below the consensus. We expect the firm to continue its investments in R&D in order to stay ahead when it comes to innovative tools not just for consumers, but also for advertisers and enterprises, further pressuring margins in 2019. We did not make significant changes to our projections and continue to value Alphabet at $1,300 per share. While the share price of this wide-moat name has increased over 9% year-to-date, the stock remains attractive at current levels. We note that in reaction to slightly mixed results, Alphabet shares were down nearly 3% in after-hours trading.

Alphabet posted total revenue of $39.3 billion, up nearly 22% year over year. Advertising revenue grew 20% to $32.6 billion as mobile search and YouTube continue to attract the ad dollars. Other revenue, which primarily consists of revenue from Google’s hardware products, its cloud offerings, and Google Play, came in at $6.5 billion, a 38% increase from last year. Waymo is not yet generating much revenue, but revenue from Fiber and Verily drove other bets revenue up 18% year over year to $154 million. While we continue to expect deceleration in ad revenue growth, we remain confident that search and YouTube ad sales, plus further growth in cloud and Google’s hardware offerings will drive total top-line growth at a 17% CAGR through 2023.

Fourth-quarter gross margin declined 148 basis points year over year to 54.4%, in line with our internal projection as growth in traffic acquisition costs appears to be stabilizing a bit. However, that was also offset by higher YouTube content acquisition and data center costs, which we think will continue. We have assumed such expenses to further pressure gross margin through 2020, after which we expect slight expansion as growth in data center costs is likely to moderate. Operating margin during the quarter was 20.9%, down 283 basis points from 2017 as Alphabet continues to increase its headcount mainly in R&D. While Alphabet posted declining operating margin in 2017 and 2018, we expect a return to margin expansion in 2020 as growth in traffic acquisition costs and sales and marketing expenses are likely to slowdown. We assume a 22% average operating margin during the next five years.

Regarding revenue, we look for Alphabet to continue to dominate the online search market, which drives consistent double-digit top-line growth. While Google is facing more competition from Amazon, we note it is also further investing in making its search and display ad platform more dynamic and easier to use. The firm continues to utilize its consistently improving machine learning technology to provide more accurate and timely responses and recommendations to advertisers. Responsive search and responsive display ads features are a couple of examples where Google helps advertisers decide in real-time what headlines or which displays and what size(s) to use for more effective ads. Alphabet is also applying machine learning to improve YouTube content delivery and ad placement. We expect revenues from YouTube (advertising and subscription revenues) to drive further growth in Google’s top-line. In our view, Google’s focus on consumer hardware is also paying off as it helps maintain most of the users within its ecosystem longer. We also remain confident that Google will continue to make progress toward becoming the world’s third largest cloud provider as it continues to invest heavily to expand the Google Cloud Platform functions and capabilities to compete with Amazon and Microsoft.

We are aware that investments to spur growth in YouTube, cloud, and hardware revenue have pressured Alphabet’s gross and operating margin. However, there are a couple of reasons why we think margin expansion could resurface in 2020. First, on the gross margin front, growth in traffic acquisition cost is no longer outpacing ad revenue growth as it did for five straight quarters before turning around in third-quarter 2018. The slower growth in traffic acquisition costs along with data center costs will partially offset the higher YouTube content acquisition cost, easing pressure on gross margin a bit. And second, we expect sales and marketing expenses as a percentage of revenue to begin to decline slightly in 2020 as Google’s cloud offering gains a stronger foothold in that market, slowing down headcount growth in the firm’s cloud sales. In addition, as Google’s YouTube possibly benefits further from the firm’s network effect moat source, we expect less sales and marketing spending on YouTube, which could create some operating leverage beginning in 2020.