It might be difficult to remember after such a strong year for Alphabet Inc (NASDAQ:GOOGL), but just a few years ago, investors were extremely concerned about GOOGL stock. (Of course, it was called Google at the time, and it was the lone share class, GOOG). The company flatlined for more than two years starting in 2010, as investors feared increasing mobile usage would pressure the company’s CPC (cost per click) numbers, impacting margins and earnings.
That wasn’t a silly concern.
Similar concerns about mobile penetration led Facebook Inc (NASDAQ:FB) to drop by almost half from its initial public offering price before rebounding. Since those days, Alphabet stock has tripled — but those concerns haven’t been completely negated.
Alphabet has managed to diversify away from advertising, or at least from a reliance on its search business. Nearly 90% of the company’s revenue still comes from advertising. But between YouTube and its Android platform, Alphabet has lessened its dependence on search. Meanwhile, the company’s various “Moonshots” offer hope for further diversification down the line.
But that underlying concern still isn’t gone. CPC rates still are declining. Online advertising growth in the U.S. is almost wholly driven by Alphabet and Facebook at this point. But there are questions about whether the overall business is that healthy, and Alphabet still has troubles overseas.
Over the past few years, Alphabet stock has shrugged off those concerns. But with GOOGL down 8% since Q2 earnings, investor attitudes may be changing.
It’s Still All About Ads
Again, the CPC concerns turned out to be valid. Cost-per-click has declined 11% in each of the past few years. The figure dropped a whopping 23% year-over-year in Q2, which explains part of the post-earnings selloff in GOOGL stock.
So far, Alphabet has more than offset those worries simply by getting more clicks. Paid clicks rose 32% last year, and 52% in Q2, driving 21% revenue growth despite the declining rates. YouTube has been the driver, as growth in the search business appears to have moderated substantially.
The question is whether that revenue growth can sustain as YouTube, in particular, matures. And with acquisition costs rising, margins may begin to compress as well.
Alphabet Needs a Few Moonshots
Alphabet does have options beyond advertising. Its “Other Bets” category includes businesses like Nest smart thermostats, Google Fiber, and self-driving startup Waymo. Alphabet also has $86 billion in cash on its balance sheet, along with minimal debt.
But there are concerns here as well.
Outside of advertising, Alphabet simply hasn’t delivered on much of its promise. Google Fiber has stalled out. The company reportedly tried to sell Nest in 2016 — just two years after it bought it for $3.2 billion. Google Home is well behind the Echo from Amazon.com, Inc. (NASDAQ:AMZN), and Google Cloud Platform similarly trails Amazon Web Services and Microsoft Corporation (NASDAQ:MSFT) platform Azure.
Investors are optimistic about Waymo. But our Brian Wu has argued that standalone valuations look excessive, and I’m inclined to agree. And given Alphabet’s struggles outside of advertising, it’s far from a slam dunk that it can outmaneuver other rivals in that space.
Alphabet does have the cash, and the ability to use it to boost GOOGL. The company reportedly has been interested in buying Snap Inc (NYSE:SNAP) after its own social media effort, Google Plus, failed. A share repurchase or even a dividend on Alphabet stock could change the case here, too.
But some success outside of advertising would help. As of yet, Alphabet hasn’t had the big hits it needs.
GOOGL Stock Looks Good, But Not Great
To be fair, it’s not as if Alphabet is all that expensive. Analyst earnings-per-share estimates for 2018 suggest a valuation of about 20 times forward EPS plus cash. Microsoft and Facebook are more expensive in terms of earnings multiples.
But there is a risk of a real slowdown here. The online advertising market as a whole doesn’t look all that healthy. YouTube still is dealing with an advertiser boycott. Procter & Gamble Co (NYSE:PG) slashed its digital ad budget by $140 million this year due to similar concerns. And Alphabet could see a further pullback if macroeconomic concerns arise.
GOOGL stock isn’t hugely overvalued — but the company has a lot of work to do. And investors who appear to be increasingly uncomfortable with large-cap tech valuations of late may not have the same patience they used to.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
