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Morningstar | Alphabet Disappoints with Weak 1Q Revenue; Maintaining $1,300 FVE; Shares Fairly Valued for Now

Alphabet reported mixed first-quarter results with a miss on the top line while operating margin widened a bit, excluding the fine imposed by the European Commission. Deceleration in ad revenue growth was more than we expected although management believes it was due to product changes which impacted demand in the short term. We expect improvement in YouTube monetization, plus accelerating growth in cloud to bring full-year 2019 revenue growth of Alphabet to around 20%. We remain convinced that Alphabet’s network effect and data economic moat sources will drive growth in the size and overall usage of Google’s ecosystem which help the firm remain the market leader in online advertising and gain traction in cloud. However, as we maintain our $1,300 fair value estimate and as the stock remains in 3-star territory (even after a 7% drop in after-hours), we recommend waiting for a wider margin of safety before investing in this name. Further pullback to the $1,000-$1,100 level would make the wide-moat and high uncertainty Alphabet stock attractive again.

Total first-quarter revenue came in at $36.3 billion, up 17% year over year, mainly due to 15% growth in advertising revenue, which stood at $30.1 billion. However, such growth in advertising decelerated more than expected. Although demand mainly on owned and operated properties remained high (paid clicks increased 39% from last year), according to management such growth was still due to various product changes. As expected, ad prices, or cost per click, declined 19%.

We expect slight acceleration in advertising revenue during the remainder of 2019 for a few reasons. First, after further adoption of Google’s changed ad products by agencies and advertisers, we believe more ads will be sold. We think that in late 2018 and early 2019, some advertisers may have reduced ad buying from YouTube until it enhanced its content and user interaction management capabilities. As we have seen before, we expect the advertisers to come back after the firm successfully implements the requested and required changes. Second, overall ad inventory for sale is likely to increase due to the firm’s continuing focus on selling more video ads on YouTube, post the product enhancement. Plus, we think steps toward more aggressive monetization of other properties such as Google Maps, may further increase ad inventory. Third, we expect higher demand for video format digital ads to slow the decline in ad prices. And fourth, we note that online ad spending remains strong this year as indicated by growth in Facebook’s ad revenue earlier this month.

While Google’s other revenue grew only 25% from last year to $5.4 billion (it grew 39% in 2018), based on management’s comments, we can assume that the cloud business was the main driver, partially offset by weakness in Google’s hardware sales, specifically, its Pixel phones. We expect strength in cloud sales to keep other revenue growth in the 25%-30% range this year and in 2020.

Alphabet’s Other Bets generated $170 million, up 13% year over year, driven again mainly by Fiber and Verily. On the Waymo front, the firm is looking to further utilize its autonomous vehicle technology for services such as logistics and deliveries. It appears that while this behemoth has invested in Lyft and Uber, and is willing to place Waymo-powered vehicles on at least one of their platforms, Alphabet may aggressively pursue what we estimate to be a $500 billion ridesharing market by 2023, and could tap into logistics and deliveries too. Another firm in Other Bets, Wings, recently got certification from the FAA (Federal Aviation Administration) to deliver via drones. So, while Alphabet’s advertising growth is decelerating, as we have been expecting, potential upsides (in the short or long term), whether from Google’s cloud, or Waymo and other Alphabet investments remain.

While traffic acquisition costs as a percentage of revenue declined nearly 130 basis points year over year, gross margin went down 82 basis points to nearly 56% due to YouTube content acquisition costs, and costs associated with data centers. During the quarter, Google was fined $1.7 billion by the European Commission due to its belief that Google has forced its clients to sign anti-competitive agreements. Excluding this fine, operating margin improved 45 basis points to nearly 23% from last year as the firm spent a bit less on sales and marketing. Alphabet expects sales and marketing expenses to pick up during the remainder of the year as investments to further speed up growth in cloud continue. We do not foresee improvement in gross margin or operating margin this year as Alphabet continues to invest in YouTube and cloud. We have modeled average annual gross and operating margins of 55% and 22% through 2023, down from the 57% and 23% the firm posted in 2018.