Alena Kravchenko
Investment thesis
Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) continues to be challenged by the macroeconomic environment today as the demand from advertisers remains soft amidst an uncertain future. That said, I think that Alphabet is pushing ahead with its top priorities around Search & AI, YouTube, Hardware and Google Cloud as it looks to improve operating efficiency in response to the uncertain environment. I continue to see that Alphabet is one of the best positioned companies in the Internet sector as it continues to have solid fundamentals in a weaker macro environment with its core competitive advantage in search looking good as it continues to invest in its artificial intelligence and machine learning capabilities.
I think that the time to buy Alphabet is when the advertising demand bottoms, which would imply the bottoming of Alphabet’s revenues related to advertising and thus the bottoming of the stock. This would typically happen when expectations bottom and as a result, when sell-side analysts’ earnings per share estimates show signs of bottoming. As such, I will continue to monitor the advertising demand as well as the sell-side analysts’ expectations revisions to determine when it gets closer to when I will be more constructive on the stock. That said, with a forward 2023 P/E multiple of 14x, this is already attractive compared to the 2008 financial crisis low of 17x P/E, and for investors who are not looking to time the market, now is a good time to increase the position in the stock.
Advertising demand weighed down by macro challenges
With the recent quarter, the key challenge that Alphabet faces is the challenging macroeconomic environment, which is impacting advertiser demand negatively. As a result, we saw Search & Other revenue growth decelerate to 4% growth year on year while YouTube revenue was down 2% year on year. The weakness was contributed by a pulling back of advertising spend as firms face an increasingly uncertain operating environment.
As we would expect, the weakest verticals were the loan and crypto verticals, while the strongest verticals were travel and retail. In my opinion, with the rising rate environment, I think that the worst is ahead of us, and I expect that the soft advertising demand will likely continue.
YouTube Shorts monetization looks to be ramping as the format now has 1.5 billion monthly viewers and 30 billion daily views. Monetization of YouTube Shorts started in September and the Shorts’ creator revenue share model will start from 2023. YouTube continues to gain share from linear TV as viewers watched more than 700 million hours of YouTube content daily.
Google Cloud
On a positive note, Google Cloud reaccelerated to 38% year on year growth in 3Q22, up from the 36% year on year growth in the prior quarter. This quarter’s growth rate was also 3 percentage points above market expectations, which highlights the resilience in the Google Cloud’s business. The $6.9 billion in Google Cloud revenue demonstrated the strong momentum we are seeing as the cloud remains a top priority for the company. With the uncertain macroeconomic environment, Google Cloud is able to continue to grow strongly due to the continued long-term trend of cloud adoption as Google Cloud brings value add to customers in the form of improvement in productivity, lower costs and unleashing new growth drivers for customers.
In Google Cloud Next 2022, the company also released more than one hundred new products and expanded relationships with customers like Coinbase (COIN), Toyota (TM), and AppLovin (APP).
There are some areas within Google Cloud that saw weakness. Management shared in their earnings call that they were seeing some deals taking longer to close, leading to some delays, as well as some deal sizes becoming smaller as well as terms becoming shorter than before.
In my view, Google Cloud’s strong momentum shows the business is heading the right way as other large cloud players like Microsoft (MSFT) and Amazon (AMZN) struggled in the recent quarter. For Microsoft Azure, the growth rate of 42% in the recent quarter reflected a 4-percentage point deceleration from the prior quarter, while its guide for the next quarter implies a further deceleration of 5-percentage points in the next quarter for Microsoft Azure. Amazon’s AWS grew at 28% in the last quarter, reflecting a deceleration of 5 percentage points from the prior quarter and a miss of market expectations by 4-percentage points. On margins, Google Cloud was also an outlier as it saw margin improvement of 2.7 percentage points to about -10% segment operating margins, while Amazon’s AWS saw operating margins decline by 4 percentage points in the recent quarter as a result of headwinds from higher energy costs, which Microsoft Azure also experienced.
As a result, when I compared the results for Google Cloud and those of Amazon and Microsoft, I see that the Google Cloud momentum continues to be resilient in a difficult market when its peers are seeing deceleration as a result of workload optimization in the case of Microsoft, and some customers pulling back their experimental budgets in the case of Amazon.
Managing costs in uncertain times
As with all the big tech firms in this period of macroeconomic uncertainty, Alphabet is also focusing on managing profitability and costs. One measure highlighted by management is to slow the pace of hiring, although this will only become more apparent in 2023.
Management guided that for next quarter, they will add headcount at less than half that in the third quarter as Alphabet continues to hire for its critical and technical roles needed for their strategic growth opportunities. As the company continues to slow the pace of hiring, the results of their actions will be more apparent in 2023, in my view. I also think that we will see management continue to focus on its four key priorities like Search & AI, YouTube (particularly on the monetization of Shorts), Hardware, and Google Cloud. I think that the continued efforts to manage costs as revenue slows given a weaker macroeconomic environment and weaker advertising market is prudent, but at the same time, Alphabet will come out of this well positioned in its top priorities.
Valuation
I use an equal weighted DCF method as well as P/E multiple method to value Alphabet. For my 2023 P/E multiple assumption, I assume a 1-year forward multiple of 22x on 2023 EPS to derive my target price. For my DCF valuation, my 10-year DCF model forecast takes into account the weakening macro trends that will affect Alphabet’s business in the near-term. I also included some weakness in Google Cloud to be more conservative in the near-term as we saw some weakness in the segment in the current quarter. All in all, I think that I was on the conservative end with my valuation for Alphabet and that it pays to be prudent in this current macroeconomic environment.
My 1-year target price for Alphabet is $125, implying 44% upside from current levels. I continue to think that Alphabet is one of the best positioned in the Internet sector and deserves to be trading at a premium given its strong competitive advantage in Search and continued investments in priorities that are growing fast like Google Cloud.
Risks
Macroeconomic environment
The biggest risk is that the macroeconomic environment could take a turn for the worse, bringing down advertising demand dramatically, leading to a fall in its Search & Other revenues and YouTube revenues that are dependent on advertising spend
Competitive pressures
While Alphabet is dominant in the global search market, there are still risks from other competitors as there may be competitors that bypass Alphabet’s search engine or other competitors that may be able to build other products, apps or networks that lead to advertising spend shifting to other platforms. For example, if advertisers see that the return on investments on advertising on platforms like TikTok is higher than ads placed on Google, this might lead to a loss in advertising spend on Google and lead to competitive pressures ahead.
Regulatory pressure
As with all other big tech firms, Alphabet is not spared from the increasing regulatory scrutiny on these large tech companies and there are definitely increasing focus on anti-trust, data and privacy issues that if Alphabet does not handle well, could lead to further advertise impact on the company.
Conclusion
I think that the time to buy Alphabet and where the risk reward gets very attractive is when the advertising demand shows signs of bottoming and sell-side analyst expectations result in bearish forward earnings per share estimates for the company. That said, as elaborated earlier, the current valuation for Alphabet based on forward P/E multiple is already lower than that when the company was in the depths of the 2008 financial crisis. I think that the company looks very well positioned within the internet sector as it continues to invest in its key strategic priorities even as advertising demand bites the company in the near-term. The strength in Google Cloud was a positive in the quarter as the company’s cloud platform outperformed peers, although there were pockets of weakness. Alphabet also remains cautious on spending as it looks to improve operating efficiency to ensure that it is ready for the uncertain macroeconomic times ahead. My 1-year target price for Alphabet is $125, implying 44% upside from current levels.
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