Alphabet (GOOG/GOOGL) reported disappointing 1Q19 earnings driven by across the board weakness in revenue trends relative to expectations.  We have noted in past earnings recaps that Alphabet was holding consistently to 20% plus revenue growth despite the company’s massive size and market share.  1Q19 saw revenue growth in the upper teens, well below expectations for the low 20s.  Given stronger than expected revenue that Facebook, Twitter, and Snap already reported, the miss at Alphabet is very surprising.  This stock is down -8% in early trading this morning, a deserved decline in Northlake’s opinion, though one we did not anticipate.  We see GOOG/GOOGL shares in the penalty box for now but given the company’s strong growth profile and reasonable valuation, we plan to hold GOOG/GOOGL shares though the turmoil.  Using new lower estimates for 2019 and 2020, our price target dips from $1,400 to $1,300.

Compounding the weaker than expected revenue trends, Alphabet management was typically quiet and closed mouth about the causes.  Lack of transparency has always been an issue for Alphabet and becomes more important following the slowest quarterly revenue growth in four years and the steepest sequential deceleration in revenue growth in seven years.  There has always been a concern that Google and Facebook market shares were so high that their revenue growth had to eventually slow or they would become virtually 100% of global digital ad revenue in a few years.  On the other hand, Google’s total addressable market seems to continually expand as it taps marketing and promotion spend and not just advertising dollars.

Management did note that “timing of product changes” impacted the quarter.  This suggests that revenue growth will pick up next quarter as new advertising products are implemented.  However, management also noted that product timing is always a factor and for at least the last four years it has never caused a revenue slowdown.

Transparency is also lacking on Alphabet’s growth initiatives in cloud, YouTube, life sciences, and self-driving cars.  The company spends heavily in these areas to create future revenues but for now these businesses produce no profit and most likely losses.  In our opinion, this lack of transparency means that despite material per share value for these initiatives, GOOG/GOOGL shares get no value for them.

There was some good news on Alphabet’s 1Q19 report.  Operating margins grew and operating profits slightly exceeded Wall Street estimates despite the revenue shortfall.  The primary debate for the last couple of years was when, if ever, profit margins would stabilize and improve signaling a return on the company’s heavy investments.  Should revenue growth pick up in 2Q19 and beyond, this first step toward improved profitability in several years could lead to a rapid rebound in GOOG/GOOGL shares.

For now, however, GOOG/GOOGL will stay in the penalty box.  We think there could be more downside in the shares in the near-term, but most of the damage is done.  Management could provide further detail on the revenue slowdown and other issues but it is more likely we have to wait until the next quarter is reported for clarity.  Northlake has always found GOOG/GOOGL shares to be undervalued given the company’s growth rate.  We hoped this would be resolved with an ever higher stock price.  Unfortunately, the 1Q19 revenue miss means that for now low valuation provides support rather than upside.

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.