Shares of Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) dropped in late October after the global internet giant reported third-quarter numbers which missed profit expectations by a wide margin. Google stock dropped more than 2% in response to the Q3 profit miss.
To be sure, the profit miss was almost entirely due to a $554 million charge from previously-announced legal settlements in France. Excluding that and other one-time charges, profits did top expectations.
But the bigger issue in the quarter was that operating profit margins yet again compressed year-over-year, continuing what has been a multi-quarter streak that dates back several years wherein Alphabet’s profit margins have eroded.
Here’s a harsh reality: During this stretch of margin compression, Google stock hasn’t done much. That is, margins started retreating in late 2017/early 2018. Since then, GOOGL stock has been stuck in a trading range between $1,000 and $1,300.
Here’s another harsh reality: Until margins start moving higher again, Google stock won’t get back to its normal winning self.
The fortunate thing for bulls, though, is that margins will eventually recover from this multi-year lull. It may not happen today. But, it should happen within the next few quarters. Once it does happen, Google stock will get back on a winning track towards $2,000.
The investment implication? Accumulate GOOGL stock on dips towards the $1,000 to $1,100 levels, and wait for margins to recover.
Margin Headwinds Have Hurt Google Stock
From a headline perspective, Alphabet has a sterling reputation on Wall Street as a “20% grower.” That is, the company has so many secular growth levers — ranging from Google Search, to YouTube, to Google Cloud, to hardware — that the company has consistently sustained a 20%-plus revenue growth rate for the past several years.
This top-line strength remains alive and well today. In the third quarter, Alphabet reported 22% constant-currency revenue growth, paced by 17% ad revenue growth and 39% “Other” revenue growth (which is mostly Google Cloud). Broadly, then, the revenue growth narrative here remains healthy, and secular growth tailwinds in digital ads, cloud infrastructure, and self-driving will support healthy growth for the next several years.
The problem with Google stock, however, is on the profitability side. Alphabet’s profit margins have been stuck in a multi-quarter decline. The culprit? Many things. At first, it was ballooning traffic acquisition costs (TAC) as a result of an ad load shift from desktop to mobile (mobile had higher TAC because it had lower click-through rates). Those headwinds have passed. TAC levels are now stable. But, margins are still dropping — operating margins squeezed 300 basis points last quarter — because of rising data-center and content acquisition costs, as well as headcount growth.
These margin headwinds first appeared in late 2017. Since then, Google stock has just bounced between $1,000 and $1,300. And with good reason. Consider this: Google stock trades at 25-times forward earnings, but Alphabet’s operating profits grew just 6% last quarter.
A 25-times forward multiple for 6% profit growth? That’s steep. Thus, so long as Alphabet’s profit growth rates remain muted — and they will, so long as margin headwinds stick around — then Google stock will have a tough time making meaningful progress higher.
These Headwinds Won’t Last Forever
The good news here is that Alphabet’s recent margin headwinds won’t last forever, and when they pass, GOOG stock should resume its march towards $2,000.
As mentioned earlier, there are basically three things which have weighed on margins over the past two years: rising traffic acquisition costs from a pivot to mobile advertising, headcount growth as a result of a big engineering push at Google, and ballooning data-center and content acquisition costs from both Google Cloud and YouTube, respectively.
The first of those major headwinds is already in the rear-view mirror, as the desktop-to-mobile ad shift has largely played out. TAC levels are now stable. The second of those major headwinds is temporary, as Alphabet is simply hiring a bunch of engineers today for product innovation. Eventually, this hiring spree will cool, and when it does, Alphabet’s operating expenses will stop rising by 20%-plus. The third headwind — ballooning data-center and content acquisition costs — will likely persist. But, it should moderate as scale helps promote cost efficiency across cloud business, and as YouTube’s originals start to gain traction in the streaming marketplace.
While Alphabet’s margins may be in retreat today, they won’t be in retreat forever. Eventually, today’s margin headwinds will pass. When they do, margins will start moving higher again. That will accompany what should be consistent double-digit revenue growth over the next several years — a combination which makes $100 in earnings per share seem doable by 2025.
Based on a historically average 20-times forward earnings, that implies a 2024 price target for Google stock of $2,000. Once today’s margin headwinds get fixed, that’s where shares will head.
Bottom Line on GOOGL Stock
Google stock is a long-term winner going through some near-term margin pains. So long as these margin pains stick around, Google stock will struggle to move meaningfully higher. But, once these margin pains pass, then Google stock will start moving higher again with great pace.
The investment implication, then, is simple. Accumulate Google stock on dips during this sideways trading era. Wait for margins to rebound. Once they do, ride the stock to $2,000 in the long run.
As of this writing, Luke Lango was long GOOG.
