Alphabet (GOOG/GOOGL) reported good second quarter earnings and the stock is reacting well, up 4.6% to start the day.  GOOG earnings are often hard to understand given the company’s complex corporate structure and strategy.  For 2Q18, the results were relatively straightforward if you ignore the cost of the latest fine paid to the European Union.  The big picture showed another quarter of strong revenue growth, improved costs controls, and continued heavy investments for future growth.  Remarkably for a company of its size, GOOG continues to grow the top line over 20%.  Investors have been concerned over the past few years about heavy spending on operating expenses and capital expenditures, but it seems clear by now that these investments are sustaining growth and perhaps opening up new opportunities.  We are especially pleased that core advertising is continuing to grow and heavy investments in machine learning and artificial intelligence are allowing the advertising businesses in Search, YouTube, and programmatic to grow rapidly despite very high market shares in a global ex-China ad business that only grows low to mid-single digits.  Investment is also high in the company’s cloud computing and self-driving car businesses.  Google Cloud and Waymo are losing money today but clearly offer the potential for massive value creation over the next few years that is not reflected in the traditional valuation measures for the stock based on EPS and EBITDA.

Credit Suisse has a good summary of the bull case for GOOG shares that closely parallels our own view:

“…we maintain our Outperform rating as our thesis based on the following factors remains unchanged: 1) monetization improvements in Search through ongoing product updates, 2) larger-than-expected contribution from Google’s larger non-Search businesses, namely YouTube, Play and Cloud, 3) optionality for value creation from new monetization initiatives such as Maps as well as the eventual commercialization of Google’s Other Bets (Waymo).”

We would also add that it appears operating expense growth and traffic acquisition cost headwinds have peaked.  GOOG margins should remain under pressure due to ongoing investments but management expects the rate at which margins contract should be slowing.  2Q18 results support this view.

We see GOOG as a “new media” stock as it takes share of advertising and content spend from traditional media like TV, radio, newspapers, magazine, direct mail, and promotions.  The better positioned stocks in those industries trade at 8-10X EBITDA and offer low single digit growth at best.  GOOG trades around 12X forward EBITDA and is sustaining 20% growth.  We see GOOG’s valuation as a bargain and see the stock rising another 10-20% over the next year as investors look forward to continued growth in 2019 and 2020.  Should Waymo and Google Cloud gain credence in the valuation, the shares could move much higher than $1,400.

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.