I’ve been relatively skeptical toward Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) stock for some time now, and as such have missed out on the big run in GOOG stock. While Alphabet stock has been mostly range-bound since late October, it has made some progress. At the least, $1,000 looks like support for GOOG, instead of the resistance that level offered last year.
But even though GOOG stock has grinded higher, my skepticism hasn’t waned. Alphabet stock admittedly isn’t particularly expensive, trading at ~20x 2019 EPS consensus, backing out its massive cash hoard.
Investors need to account for the losses Alphabet is racking up in its “Other Bets” division. Excluding those investments (which can be turned off at any point if they don’t result in earnings), GOOG looks even cheaper.
With all that said, I still see reasonably significant risk to Alphabet stock going forward. And recent developments, including what looked like a Q1 earnings beat, seem to highlight, not minimize, that risk.
Advertising Growth and Margins
One of my long-running concerns about GOOG stock is its reliance on advertising. Google dominates the online advertising business along with Facebook, Inc. (NASDAQ:FB), which at first glance would seem like a good thing.
Long term, that’s not necessarily the case, however. Online ads are growing — for now. But there are a number of clear risks to Google’s business on that front.
The first is the company’s struggles with monitoring content on its key YouTube platform. YouTube already has seen major advertisers like Unilever NV (ADR) (NYSE:UL) and Procter & Gamble Co (NYSE:PG) cut their advertising due to concerns about exactly what type of content was running after their ads.
That issue has popped up again, after Cisco Systems, Inc. (NASDAQ:CSCO) paused its advertising due to similar concerns. With regulators worldwide likely paying closer attention amid the scandals at Facebook, YouTube needs to get its house in order.
The second issue is whether search — which Google dominates — will continue to be the entry way to the internet. As apps continue to proliferate, the long-term risk to Google is that users will get their information outside of the browser. Alphabet obviously can monetize those apps to some extent through its Android OS, but not to nearly the same level of profitability.
Meanwhile, the search business itself continues to see lower margins, as was the case in Q1. Operating margins for the Google segment fell from 30% to 27% in the first quarter. TAC (traffic acquisition costs) continue to rise, and cost per click (essentially, pricing) continues to fall.
Higher clicks, which rose 59% year-over-year in the quarter, have offset those pressures, allowing Google profits to grow. But if that usage growth decelerates, Alphabet earnings could also decelerate — and sharply. And that deceleration could come from higher app usage, an entry by Amazon.com, Inc. (NASDAQ:AMZN) into the ad industry, and/or lower growth in YouTube viewership.
Can Other Bets Drive GOOG Stock Higher?
Alphabet continues to lose money on its Other Bets businesses, which have posted losses of about $3.2 billion over the past four quarters. That suggests an after-tax drag of about $4 in EPS.
That in and of itself isn’t necessarily a problem; in fact, it’s a logical strategy. Google is using some of the impressive cash thrown off by the advertising business to diversify itself and better position itself to enter new businesses.
But while I’ve admitted to seeing some potential in those businesses, I’m starting to question just how valuable those Other Bets really are. Self-driving car unit Waymo continues to make progress, with a commercial launch on the way in Phoenix.
Elsewhere, though, I’m not sure Google looks like a big winner (and autonomous driving itself will take years to sort out winners and losers). Google Cloud hit $1 billion in revenue a quarter last year, which leaves it well behind Amazon and Microsoft Corporation (NASDAQ:MSFT). Google Home trails Amazon’s Alexa in smart speakers.
As Brad Moon pointed out, a shift in Alphabet’s financial disclosures shows that Nest brought in $721 million in revenue last year. At a valuation of 10x revenue (which seems hugely generous), that business would account for roughly 1% of the value of Alphabet stock.
Alphabet’s efforts in AI are intriguing. Google Duplex has generated a lot of buzz. But GOOG stock still is worth three quarters of a trillion dollars. It takes an awful lot of buzz to support that kind of valuation.
What’s Alphabet Stock Worth?
None of this is necessarily to suggest that Alphabet stock is massively overvalued or a short. But with Google segment operating earnings growth about 10% in Q1, a high-teen multiple to 2019 EPS (excluding Other Bets losses) doesn’t seem hugely attractive.
In fact, at the risk of focusing on round numbers, the $1,000 level which has provided support actually looks about like fair value to my eye. But I’m not sure it leaves much room for upside.
Unless Alphabet finds a big winner in Other Bets, or the advertising business finds another gear, earnings growth likely will slow. And if that’s case, I’m not sure how much higher GOOG stock can really go.
As of this writing, Vince Martin has no positions in any securities mentioned.