Shares of Alphabet (NASDAQ:GOOG) popped more than 10% in late July after the internet giant reported second quarter numbers which smashed expectations across the board. Investors cheered the report. Analysts raised price targets. Google stock zoomed higher.
The report itself was very good. Revenues came in better than expected – in every business and every geography – and revenue growth accelerated from the first quarter. That’s big, because revenue growth had been flattening out for several quarters.
Meanwhile, margins came in substantially ahead of expectations and were almost flat year-over-year. Again, that’s huge, because margins have been in free fall over the past several quarters.
The sizable revenue and margin beats paved the way for profits to breeze past expectations. Alphabet ended up posting its biggest EPS beat, ever. They also reported their biggest year-over-year operating profit gain in recent memory.
Net-net, the quarter was very good. Google stock wasn’t very expensive heading into the print (23-times forward earnings, versus a 52-week-high valuation of 30-times forward earnings). Nor had it rallied in a big way (up 8% YTD, versus a 20% gain for the S&P 500). That combination of strong numbers and a relatively depressed and cheap stock makes the 10% post-earnings rally in GOOG stock seem very reasonable.
But, will the rally continue? I think so. Second-quarter numbers were good enough – and Google stock is still cheap enough – that this stock has fundamentally supported runway to prices above $1,300 by the end of 2019.
Alphabet’s Q2 Print Checked off Two Big Boxes
Alphabet’s second-quarter earnings report was very good because it checked off the two big boxes it needed to check off. Heading into the print, investors were really concerned about revenue growth deceleration. Alphabet has been a 20%-plus revenue growth company for the past several years, but that streak was broken in the first quarter of 2019.
The company reported 19% constant currency revenue growth, down from 23% in the fourth quarter of 2018, led by a slowdown in the ad business to a multi-year low 15% growth rate and a similar slowdown in the Other business (which is mostly Cloud) to a multi-year low 25% growth rate.
The second-quarter print erased those concerns. Constant currency revenue growth accelerated quarter-over-quarter to above 20% again. Ad revenue growth accelerated to 16%. Other revenue growth accelerated to 40%, the highest growth rate it has posted in several years.
Meanwhile, investors have similarly been concerned about compressing margins at Alphabet. Broadly, the pivot from desktop to mobile advertising has had an adverse impact on Google’s advertising business, while the ramp in Other businesses has provided a drag on margins, too. The result? Operating margins have been falling by several hundred basis points year-over-year for the past several quarters.
That operating margin compression eased significantly in the second quarter. Operating margins dropped just 100 basis points year-over-year, marking the smallest margin drop in recent memory. Further, a big part of that compression was driven by currency headwinds, so the FX neutral drop in margins was actually less than 100 basis points.
Overall, Alphabet addressed both revenue growth deceleration and margin compression concerns in the Q2 print and showed with numbers that those trends are starting to reverse course.
Google Stock Has Upside to $1,300
Zooming out, there’s a lot to like about Alphabet’s long term drivers.
The core search business continues to improve with more AI technology and shopping integrations. Google’s other properties continue to grow engagement by incorporating smarter capabilities, such as Gmail AI (which can complete email sentences for you) and Maps AI (which can tell you when a bus is delayed).
The smartphone business is gaining significant momentum (Pixel sales more than doubled year-over-year in Q2) at the same time that the iPhone business over at Apple (NASDAQ:AAPL) is plateauing.
Further, YouTube continues to improve revenue capabilities with things like Super Chat, Channel Memberships, merch, YouTube Music, and YouTube Premium. Smart home demand continues to ramp under the Nest umbrella. Google Stadia, the company’s cloud gaming platform, is leading the gaming industry into a new era. Waymo continues to build momentum in the self-driving world.
All in all, there are a ton of positive long term growth drivers here. All of them are progressing favorably. Thus, it should be no surprise that revenue growth remains robust and margins are starting to stabilize with scale. It should also be no surprise that robust revenue growth and margin stabilization project as the norm going forward.
Revenue growth over the next several years should run in the 15%-plus range, accounting for some slowdown due to the law of large numbers, but not much because there are so many growth drivers here. Meanwhile, operating margins should trend slightly higher as the company’s non-core businesses scale and start to turn a meaningful profit.
Modeling those assumptions out, $105 in EPS seems entirely doable by fiscal 2025. Based on a historically average 20-times forward multiple, that implies a fiscal 2024 price target for Google stock of $2,100. Discounted back by 10% per year, which equates to a fiscal 2019 price target of just over $1,300.
Bottom Line on Google Stock
Strong Q2 earnings from Alphabet underscore that all is well in the Alphabet kingdom. The core search ad business is doing just fine. YouTube is doing really well. Google Cloud is gaining tons of momentum. The hardware and smart home businesses are starting to bear some meaningful fruit.
These drivers paint a positive long term growth picture for Alphabet. That positive long term growth picture supports Google stock at prices above $1,300 by the end of 2019.
As of this writing, Luke Lango was long GOOG.
