Alphabet (GOOG/GOOGL) reported a second consecutive quarter of blowout earnings, smashing consensus estimates on all line items.  Most impressive to us was 38% operating margin, about 700 basis points ahead of expectations.  It was only a year or two ago that investors were very concerned about GOOG/L profitability as the company invested aggressively across each of its major business lines and its other bets. 

Management has cautioned for a few quarters that profit margins are getting a boost from less marketing spend during the pandemic – digital traffic is so high that there is little need to spend money to attract pageviews.  We expect margins to settle back somewhat beginning in 2H21 as comparisons toughen.  However, we believe that GOOG/L has moved the margin bar permanently higher due to a combination of factors. The impact of CFO Ruth Porat who was hired six years continues to be felt.  She has brought much greater discipline to operating expense control.  GOOG/L also is benefitting from its large and ongoing investments in AI and machine learning that are making it easier for Search and YouTube advertisers to execute advertising plans.  This provides operating leverage to GOOG/L as it increased advertising budgets at lower cost for the company to deliver.

The story at GOOG/L is far from just profit margins.  Revenue continues to grow very rapidly against 2019 levels (comps vs 2020 are distorted by the initial economic shutdown) at a pace ahead of pre-pandemic growth.  The pandemic clearly has boosted the digital economy.  There is a question of how much of the incremental growth is pull forward vs. a new higher base.  Northlake’s opinion is that the digital economy is taking share at a more rapid pace.  Revenue growth in Search, YouTube and Google Cloud will inevitably slow, but we believe it will settle at rate at least as high as the pre-pandemic level of 15-20% off a materially higher 2021 base than was expected two years ago.

Northlake is very comfortable continuing to hold GOOG/L shares.  However, after a gain of 57% so far in 2021, the upside to our target is only about 10%.  The exceptionally strong 2Q21 results combined with the signal they send about sustainable revenue growth and profit margins leads us to increase the estimates we use for the purpose valuing GOOG/L shares.  Notably, our estimates continue to include multibillion-dollar losses for Google Cloud, Waymo, and Verily.  Our target increases from $2,900 to $3,000 and includes a conservative valuation for the money losing businesses.  The shares currently trade a reasonable 23X 2022 estimates and would be at 25X at our target, a reasonable valuation with the S&P 500 trading at 20X.

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.