Google (GOOG/GOOGL) shares fell after reporting 4Q17 earnings. Revenue growth remained remarkably strong, rising 24% year over year, but Traffic Acquisition Costs (TAC) and other operating expenses rose even faster leading to margin compression and EPS below expectations.
The debate for Google investors has long been focused on (1) the sustainability of revenue growth, and (2) the cost of sustaining growth. There has been long-term concern that revenue would decelerate due to competition or the just the maturity of the search business. Prior to the arrival of CFO Ruth Porat a couple of years ago, the company had a habit of missing operating margin expectations and appearing to have poor cost controls or return on investment discipline. While revenue growth no longer seems a concern – it has actually accelerated in the past year – 4Q17 marked the first time in a couple years where expenses were well above expectations.
Northlake is forgiving of the expense growth given that it appears focused on driving big initiatives and signs of success are abundant. MoffettNathanson Research captured it succinctly:
“As Google enters its 20th year, it’s remarkably still posting revenue growth above 20%. We are hard pressed to find another company outside of Amazon that has ever achieved this rate of growth this late in its lifecycle. Obviously, this track record speaks to the greatness of search as a business, but it also talks to the company’s continuing focus on finding and investing in future areas of growth.”
The investment continues in search and YouTube but is also focused on Google Cloud, YouTube TV, Waymo (self driving cars), and Nest. Cloud and YouTube TV look very promising and are already scaling revenue and subscribers. Waymo will be launching a full scale driverless ride sharing service in Phoenix this year. As a money manager focused on long-term growth in quality companies for our clients, Northlake is tolerant of periods of heavy investment as long as the money seems to be spent wisely. A single quarter acceleration that pressures margins is not very worrisome, especially when it comes during the holiday season where support for new products is naturally heaviest.
Management explained the elevated spending well on its 4Q17 conference call and noted the long running pressure from TAC should begin to ease later in 2018. We see Google headed for around $50 in 2019 EPS, enough to justify a stock price above $1,250. The renewed concern about operating margins could linger but we feel patience is warranted.
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.