Over the past few years, Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) has made a concerted effort to diversify from its legacy Google Search business. Like rival Amazon.com, Inc. (NASDAQ:AMZN) and Microsoft Corporation (NASDAQ:MSFT), Alphabet took to the cloud and other initiatives it hopes will pay off for GOOGL stock.
The company’s Waymo unit is developing self-driving cars. “Learning thermostat” Google Nest and Google Home provide an entry into the Internet of Things realm; Google Fiber provides high-speed internet access; and the Verily unit provides research in life sciences.
As GOOGL stock tries to return to an all-time high reached in mid-March, the potential growth opportunities beyond Google Search are a big part of the bull case.
So far, those investments aren’t really moving the needle: 88% of Alphabet’s 2016 revenue still came from advertising, per the company’s 10-K. That is a potential problem for GOOGL stock holders. The online advertising business doesn’t seem particularly healthy at the moment.
Google’s YouTube lost a number of clients in Europe amid concerns about the type of content being run next to advertisements. The shift to mobile creates a continuing headwind in terms of pricing. 2016 growth numbers were impressive, but competition from social media providers may limit that growth going forward.
That leaves GOOGL stock somewhat reliant on non-Search initiatives, and in particular what the company calls its “Other Bets.” And in many of those efforts, Alphabet appears to be falling behind.
GOOGL Stock Is at Risk
It might seem premature, if not downright silly, to express concern about Alphabet’s core advertising business. Concerns about cost-per-click (CPC) rates did pressure GOOGL stock a few years back, but growth was impressive in 2016. Overall revenue increased 20%, despite 4 points of currency headwinds.
Google-owned properties saw growth accelerate to 22% from 16% the year before. The AdSense business (which Google refers to as Google Network Members) is seeing smaller sales increases, but still grew more than 3% in each of the past two years. Meanwhile, “other” Google revenue jumped up 41%, which the 10-K attributed to app sales through Google Play.
Looking forward, however, there are legitimate concerns. Competition is only going to increase, in particular from social media giants Facebook Inc (NASDAQ:FB) and Snap Inc (NYSE:SNAP). Both companies — along with Twitter Inc (NYSE:TWTR), although I’m highly skeptical of TWTR’s chances — can offer more direct, more personally tailored advertising options. And, of course, Amazon represents a real threat to Alphabet. That company has a strong ad opportunity of its own, and at least one analyst believes the Amazon Echo could pressure the entire search model longer-term.
Even in recent numbers, there are concerns. The most notable is that cost-per-click continues to decline, largely a result of the continuing shift to mobile. The AdSense business is rather stagnant at this point. Growth in Android usage and increasing share for the Chrome browser and Google Docs have helped, but those tailwinds will fade, if only due to the already-large proportion Google owns in both markets.
There’s a real, “okay, then what?” concern about what happens to GOOGL stock once “click growth” slows.
Alphabet Isn’t Winning
With GOOGL stock still pricing in a reasonable amount of growth, Alphabet must succeed beyond advertising. Its early efforts haven’t been promising, as Nest simply hasn’t grown the way Google expected. What’s more, two key executives on the Google Fiber project were reassigned last week, implying a retreat from that initiative; Google Home is behind the Echo; and Google’s cloud hosting similarly trails both Amazon and Microsoft’s Azure.
Waymo’s role in self-driving cars is yet to be determined, admittedly. The Pixel smartphone is an opportunity (although many companies have failed in that space, including Amazon and Microsoft). And investors do need to remember that the company is spending lavishly outside of Search.
The “Other Bets” category lost about $3 billion last year, a significant headwind to earnings (almost $4 per share after-tax). Even if Alphabet has to pull back on some of these initiatives — as appears to be the case with Google Fiber — earnings will benefit. But if ad growth slows to single-digit growth, there’s probably not enough to support the current price of GOOGL stock.
GOOGL Stock Looks Familiar
All told, GOOGL stock is more dangerous than it looks. Alphabet’s current situation reminds me quite a bit of what Microsoft looked like at the end of the past decade. Microsoft’s dominant PC platforms — Windows and Office — were still growing, but it was clear that pressure was on the way. For the most part, Microsoft’s efforts to diversify did not work.
MSFT stock subsequently traded at a low-teen multiple to earnings, barely moving for several years until optimism surrounding “the cloud” provided a tailwind.
It’s not hard to imagine a similar fate for GOOGL stock over the next few years. If advertising slows, as seems likely, and Alphabet can’t find a secondary driver, which seems possible, then GOOGL isn’t going to hit $1,000 or anywhere close. That’s one possible scenario investors need to keep in mind.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
