Alphabet (GOOG/GOOGL) shares seem likely to take a breather following the company’s 2Q17 earnings report. Overall, we would give the report a solid “B” but with the shares having soared 26% this year before the report an “A” was probably required to sustain the momentum. The report showed remarkable growth in Google’s mobile search, YouTube, programmatic advertising, and cloud business units. However, this growth came at a cost due rising expenses to acquire traffic and a continuation of a long running mix shift toward lower priced advertisements in mobile search, YouTube, and programmatic. Northlake is willing to take this trade off as GOOG/GOOGL remains a great value with 15-20% revenue and EPS growth against just an average P-E multiple after adjusting for almost $100 billion held in cash on the balance sheet. In a world where even 5% growth is tough to find, we are willing to wait out transitional periods in GOOG/GOOGL’s financial performance. Furthermore, the bear case around GOOG/GOOGL has long revolved around the company’s search products losing relevancy in a shift to mobile. Given the remarkable 52% growth in paid clicks, the highest in at least seven years, it is quite clear that GOOG/GOOGL has remained a leader while effectively making the transition to a mobile world.
The rub against GOOG/GOOGL this quarter is that operating margins contracted for the first time in about two years. For many years, the bear case was focused on undisciplined spending that would waste the remarkable growth and profitability of the search business. Two years ago, the company hired a new CFO and profit margins and capital spending quickly showed discipline despite the shift to mobile driving traffic acquisition costs steadily higher. In 2Q17, traffic acquisition costs accelerated while more traditional operating expenses and capital spending trends also deteriorated modestly.
Against the remarkable high volume and revenue growth rates, we do not see this as a problem but rather as the cost of doing business. The alternative is the true bear case – slowing growth as trends in mobile internet shift away from Google products and services. Management commentary did not indicate concern with the 2Q mixture of financial and operating metrics but neither did they indicate that things would change in the near future. We see this as a transitional period with GOOG/GOOGL likely to emerge with its growth rate and profit margins intact. Thus, we see good value in GOOG/GOOGL shares at about 20X year ahead earnings after adjusting for net cash. Until Wall Street estimates rise again, upside may only be another 10-15% over the next 6-12 months but GOOG/GOOGL remains a core holding.
GOOG/GOOGL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. GOOG/GOOGL is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.