Alphabet (GOOG/GOOGL) reported a mixed quarter relative to very high Wall Street expectations but a good quarter looking to long-term value creation.  Revenue and EPS came in ahead of expectations although the EPS beat was a one-time item.  Operating Income disappointed as expenses were well above expectations, an ongoing issue for Alphabet over the past several years.  Management does not provide guidance but did note that headcount growth would slow and capital expenditures would be significantly less in 2019.

Alphabet again reported north of 20% revenue growth in its advertising business as it has every quarter for the last several years.  Advertising is now a at a run rate of more than $120 billion annually which makes this growth rate exceptional and rare among large American companies.  The cost of sustaining this growth is what worries Wall Street as the law of large numbers suggests that eventually the growth rate must slow.  After all, there is only so much money spent on advertising and promotion globally and that pot of dollars is only growing in line with global GDP growth or around 3%.

Like many investors, we are frustrated by the heavy level of ongoing investment at Alphabet.  However, it is clearly the correct strategy to position the company for sustained, well above average long-term growth.  The stock is reasonably valued on P-E to Enterprise Value to EBITDA (our preferred metric), trading at just a small premium to the average company.  IT is quite clear to us that Alphabet is well above average.

Beyond sustaining growth in the advertising business by supporting the search business and YouTube, Alphabet’s investments are creating value in health care at Verily, self-driving cars at Waymo, and cloud services at Google Cloud.  We see little evidence these opportunities are being incorporated into the valuation of Alphabet shares even as similar growth opportunities at companies like Amazon, Netflix, and Microsoft receive premium valuations.

Northlake continues to favor investment in Alphabet and sees the potential for 20% upside in the shares over the next year driven by continued revenue growth and some moderation in expense growth and capital spending.  Management comments about expense growth moderating are consistent with those made about Traffic Acquisition Costs and improvement in TAC occurred as promised giving us confidence the moderation will in fact occur.

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.