Alphabet returned to nearly pre-pandemic growth in 3Q20 led by Cloud and YouTube.  Advertising revenues grew 15% adjusted for foreign currency, just below the high-teens level of late 2019.  Revenues, margins, and operating profits all surprised materially to the upside, with the overall results relative to consensus estimates the biggest positive surprise in many years.

Strength in advertising is even more impressive given that 15-20% of Google advertising is related to travel and hospitality, where spending is still down over 80%.  Coupled with a slight acceleration in Google Cloud Platform revenue growth to 45%, estimates for 2020 and 2021 revenues are moving higher.  Perhaps more importantly for the stock price, Alphabet reported its highest operating margins in two years.  Better than expected revenue helped produced operating leverage.  However, good expense control, hardly a hallmark of Alphabet management, was also evident.  Operating expenses grew in the mid-single digits, leading to an operating margin of over 24%, a full 3% above analyst estimates.  Alphabet has improved its expense control since Ruth Porat was hired as CFO five years ago.  Nonetheless, steadily lower operating margins as Alphabet pursued its many initiatives from health care to cloud to self-driving cars has been a point of frustration for investors and held back valuation for Alphabet shares.

Another frustration for investors has been poor transparency into the company’s financial results including the results in the various segments.  Similar to expense control, there has been some progress over the last five years.  Most recently, the company began breaking out YouTube revenues.  In conjunction with the 3Q20 report, Alphabet announced they would be breaking out Google Cloud Platform into its own segment.  This should serve to highlight an important growth business that is reaching material scale in revenue.  In addition, it is likely that GCP has been operating at a loss or very low margin. If this is the case, the new reporting structure could also highlight better operating margins for the core advertising driven businesses.  At a minimum, another step toward improved disclosure and transparency should help build investor confidence.  The parallel may not be perfect but Amazon shares benefited greatly when the company began to break out the financial performance of its industry leading cloud platform, Amazon Web Services.

Northlake believes that 3Q20 will be seen as critical quarter for Alphabet shares.  GOOG shares are up nicely in 2020 but have lagged far behind other COVID winner tech giants like Amazon, Facebook, Microsoft, and Apple.  GOOG is up over 4% today while the other stocks are down 4% plus on average.  We think a catch up move for GOOG is coming.  Our revised target is 15 times 2021 projected EBITDA plus a portion of the hidden value for other bets like Waymo and Verily, equating to $1,900 or 17% upside.  It will take a couple more positive quarters to provide the catalyst for these gains but our confidence is improved off the stellar 3Q20 results.

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.