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Morningstar | Mixed 3Q Results, but Alphabet's Ad Revenue Continues to Grow Strongly; Shares Undervalued. See Updated Analyst Note from 25 Oct 2018

Alphabet posted slightly mixed third-quarter results with revenue a bit light because of a foreign exchange headwind, while operating margin came in above our estimate and in line with consensus. Growth in ad revenue remained strong, which we think demonstrates the health of Alphabet’s network effect economic moat source in that segment. However, deceleration in other revenue growth was disappointing. We expect revenue growth in that segment to pick up again in the fourth quarter due to the seasonally higher hardware sales and some return on Google’s continuing investment in its cloud sales team. Operating margins were helped by what appears to be some stabilization in traffic acquisition cost as a percentage of revenue.

We have not made significant changes to our model and our $1,300 per share fair value estimate of this name is intact. The stock hit 4-star trading level yesterday and is down 3%-4% in after hours. At these levels, we think Alphabet shares have become more attractive as we remain confident that the firm’s network effect and data economic moat sources will continue to drive growth in the size and overall usage of Google’s ecosystem. We think this will help the firm remain the behemoth in online advertising and make further headway in consumer hardware and enterprise cloud businesses. Plus, future upside possibly brought forth by Other Bets may becoming more realistic as Alphabet’s autonomous vehicle technology provider, Waymo, has begun to test commercializing its rides.

Total third-quarter revenue came in at $33.7 billion, up 21% year over year and 22% in constant currency. Ad revenue grew 20% from last year to $29 billion on the back of the continuing increase in mobile device usage and more viewership of content on YouTube. Demand for ads on Google properties remains strong as ads sold were up 62% from last year, impact of which was partially offset by a 28% decline in prices.

We expect Google to further increase its ad inventory as it continues to monetize its various apps with advertising. Inventories sold on Google’s network properties went up 1% accompanied by 11% growth in prices as demand for programmatic advertising and Google’s ability to monetize third-party apps via AdMob was strong. In addition, as we had anticipated after Alphabet’s second-quarter call, we think the impact of General Data Protection Regulation, or GDPR, on ads sold on network properties is lessened, as displayed by the volume and price growth.

Regarding another issue that Alphabet is grappling with in Europe, the firm is now appealing the $5.1 billion fine imposed by the European Commission, or EC. However, according to a report published by The Verge, Alphabet has also taken steps to comply with EC demands by forcing Android smartphone makers to pay Google a fee to make Google’s apps available on their devices. The article also states that Google is offering device makers the option to pay a lower fee if they put Google’s Chrome browser and its search on their phones. Depending on the outcome of Google’s appeal, such a strategy could provide the firm another opportunity to further monetize its apps and other offerings, as we do not expect Google’s two-sided network effect moat source to be impacted. As mentioned in our prior notes, whether Google forces OEMs to pay or not, consumers will continue to download and use Google apps as they have been working well for a long time. While there are no switching costs for consumers, we believe the network effects of most of those apps will remain, especially given Google’s improvement of its machine learning technology which continues to enhance search results. As a result, we expect demand for the apps to continue to grow, forcing OEMs to pay Google and place them on their devices as default, whether forced by Google or not.

Other revenue grew 36% year over year to $4.6 billion, which in our view was slightly disappointing as we expected cloud revenue to keep growth in that segment above 40%. However, we think this may have been due to weaker hardware sales right before the Holiday Season. We note that Google did take steps to further accelerate cloud revenue growth as it increased the cloud headcount, mainly the sales team, during the quarter. We expect growth in Google’s other revenue segment to be significantly higher in the seasonally strong fourth quarter, and estimate a 43% growth this year.

Other Bets’ revenue came in at $146 million, representing 25% growth, which we did not find very impressive as Fiber revenue growth is likely decelerating further. We note that Other Bets’ Waymo does represent an attractive call option as Alphabet is now testing various pricing models on riders participating in Waymo’s Early Rider Program, which was free initially. Management also indicated that its Waymo may be looking into providing the technology for other services such as logistics and deliveries. We think those services may be similar to what other companies such as Uber and Grubhub are providing.

Operating margin declined more than 3 percentage points year over year to around 25% driven mainly by lower gross margin due to more content acquisition costs and costs associated with the firm’s growing number of data centers. We note that traffic acquisitions costs as a percentage of ad revenue remained steady at around 23%, similar to second quarter, and did not further impact gross margin negatively. We don’t expect improvement in gross margin or operating margin this year or next mainly due to further content acquisition by Google’s YouTube.