Alphabet’s (GOOG/GOOGL) headline 3Q19 earnings release was mixed but after adjusting for one-time items, the report was a good one albeit lacking the upside relative to consensus estimates the company reported last quarter.  Most importantly for Northlake, Alphabet showed strong advertising growth above 20% reinforcing the rebound in 2Q19 after the unexpected deceleration in growth in 1Q19.  Northlake sees Alphabet as a core holding offering superior growth in a low growth world at a barely above average valuation.  We think the core businesses of Search and YouTube can sustain their growth as Alphabet also taps into large addressable markets and new businesses such as Cloud, Waymo (driverless cars) and others to extend the company’s growth many years into the future.  We are ignoring the significant advancements in neural networks and quantum computing discussed on last night’s conference call.  Cloud, Waymo and other businesses offer great value to shareholders.  If they were standalone companies they would be worth billions of dollars while inside Alphabet they are still in investment mode thus making GOOG/GOOGL shares appear more expensive.  We call this hidden value in our valuation approach and believe they easily add at least 5-10% to GOOG/GOOGL’s valuation.  We see another 10-20% upside in Alphabet shares over the next year and continue to see the stock as a core holding for Northlake clients.

Looking a bit more closely at the quarter, we were pleased with revenue growth and believe adjusted operating margins were as expected.  There is some fuzziness on expenses which has been a long running concern.  How much does Alphabet have to spend to drive growth in core mobile and desktop search as the scale of these businesses is so large?  Will YouTube have to spend heavily on content to compete with Netflix, Disney, AT&T, and Comcast in the streaming wars?  What level of investment is necessary to bring Google Cloud and Waymo to profitability?  These questions have dogged Alphabet for years and management commentary on the conference call reminded investors that the company will continue to invest aggressively against large market opportunities and that the timing of those investments is hard to predict.

Investor concerns about operating expenses and the sustainability of advertising revenue growth against always high expectations make GOOG/GOOGL shares particularly volatile around earnings reports.  The stock moved up 5% over the past few weeks and is initially trading down -2% after the report.  We do not read too much into these short-term moves as we see Alphabet as taking the right steps to sustain well above average growth in revenue, profit and free cash flow.

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.