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It was a busy second half of July for Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), which released its second-quarter earnings less than two weeks after executing a stock split, multiplying the number of shares in the company by 20x. Since then, the stock has more or less treaded water, only just now returning to it pre-split price after earnings reports.
I find this rather surprising, since Alphabet’s earnings were just about as good as could be expected, and far, far better than most of its peers. But the economic overhangs on what remains a principally advertising driven stock do give some reason for caution.
Time To Retire The Share Split?
In general, I think this entire idea of associating stock splits with a surge in price is probably long past its shelf life. In terms of economic theory, it was always true that a stock split wouldn’t matter – divide the same amount of profit over 20x as many shares and each share is only worth 5% as much. Keep the shares whole and you have 5% of the shares at 20x the price.
Despite this, historically, splitting shares has produced (to varying degrees) upticks in share price. This is because economic theory never perfectly translates to reality. Specifically, economic theory in general often fails to fully consider the impact of disparate incomes: if someone thinks a share is worth $1000 but only has $150 to buy it with, that share may go to someone who only thinks it’s worth $900 …but actually has the cash.
Thus, splitting shares brings more buyers with low capital but high hopes for a stock back into the market as effective buyers. This drives the share price up, after adjusting for the split.
But the world is rapidly changing. More and more brokerages, of both the traditional and digital variety, have been embracing the concept of trading fractional shares. Under this system, a buyer simply says how much cash they wish to allocate to a stock. The system then pairs them with other, similarly cash-strapped fractional buyers and buys a share on behalf of all of them.
This means that a lower-capitalized buyer is never priced out of the market, and thus correspondingly the effect of share splits is diluted.
A Strange Trading Pattern
Even so, while I’m not surprised, in general, to see that share splits are losing their effectiveness, I am surprised that Alphabet is only just now returning to its pre-split price. At a time when everyone from Roku (ROKU) to Comcast (CMCSA) is taking a bath on earnings – Meta (META) even reported its first-ever fall in revenue – why is one of the few companies that actually managed to beat expectations and doesn’t seem to be taking a hit from the coming recession only managing to tread water?
One possible explanation is that some people bought the stock in anticipation of a post-split bounce and are now selling into it, diluting and retarding any rally. But another is that the market thinks Alphabet has another shoe to drop in the next few quarters.
On its face, this is understandable. Google’s second-quarter earnings made clear that, while Google Cloud and certain subscription based services like YouTube Premium are still advancing, Alphabet remains overwhelmingly an advertising company, with ads accounting for over 80% of revenues. Advertising is exceptionally vulnerable to economic recessions, so some investors might be concerned that Alphabet, of all companies, can’t possibly escape unscathed.
The economic picture right now is mixed. On the one hand, rising interest rates are absolutely crushing stocks, and the GDP report has now been negative for two straight quarters, which technically means we are already in a recession, not just anticipating one. But on the other hand, employment growth hasn’t stopped and consumers are still spending. If consumers are still spending and employers are still hiring, will an advertising slowdown really drag on for very long? Or does the advertising slowdown indicate that hiring and spending are bound to follow it down?
The Other Other Shoe
Truth be told, I’m not certain yet, and I really want to see some more earnings reports before I decide. If I was evaluating Alphabet solely on its current business operations and the macroeconomic picture, I’d be somewhere between a very cautious Hold and a very reluctant Sell. But the recession, while it may very well trigger some sort of pressure on Alphabet’s advertising revenues in Google Search, may also deliver to Alphabet a gift, in the form of a vanquished rival for a major new revenue stream.
No, I’m not talking about Meta – though after that Instagram debacle the other day where it staunchly defended itself from criticism from prominent media personalities like the KarJenners for precisely one day before buckling, I certainly could be talking about Meta. No, I meant cable-TV.
Wait, Don’t Leave!
I know I probably just lost half my readers with that last sentence, so please give me a chance to explain before you click away. I know YouTube’s position in US pay-TV is not really that substantial right now, even with YouTube TV’s announcement that it just crossed five million subscribers last month. That is not nothing. It means it’s now good for fifth-largest service – not virtual service, any pay-TV service – in the United States, the world’s most lucrative media market.
But in the context of Alphabet’s tens of billions of dollars per quarter in revenue, it remains a sideshow. I’m not talking about YouTube TV so much – well, I am, but I’m not just talking about YouTube TV. If pay-TV in the US is about to enter a terminal decline with rapid acceleration, that has implications for increased Google profits in other areas of the company as well.
What Terminal Decline?
Let me put the qualifier in a little context first, and then we will examine the implications for Alphabet. If you missed it, last week saw the two largest pay-TV operators in the US, the cable giants Comcast and Charter (CHTR) report their earnings. And they were absolutely terrible, for so many different reasons.
But the reason most relevant to us here is that Comcast reported that its linear TV business is now declining at a nearly 10% annual rate. Verizon is nearly as high, and DIRECTV, the third largest player, is either as high as Verizon or may even be much higher than Comcast.
We don’t know because DIRECTV doesn’t report subscriber totals since going private and leading analysts can’t agree on the total. If it lost 300,000 in Q1 it’s declining at 8%, if it lost almost 500,000 it’s declining at 15% per annum! And it’s about to lose NFL Sunday Ticket, so whatever rate it’s declining at, it’s probably about to start declining much faster next February.
What A Dying Bundle Looks Like
The general expectation has always been that the decline will accelerate until it hits a hard floor: the 50 million or so people who absolutely must have live sports and news. These, it is argued, will never leave the Pay-TV bundle, so they’ll simply pay whatever higher prices are necessary to preserve it when everyone else is gone.
The problem with this is two-fold. The first is that I don’t think some analysts fully appreciate just how unaffordable the pay-TV bundle will be at that point. The cable bundle is now the most expensive utility in the average house, ahead of electricity and Internet and water and heat and pretty much everything that would be considered a good deal more essential. At some point, the lower-income sports lovers – and there’s no reason to think sports fandom somehow drops off with income – just can’t pay.
But secondly and more demonstrably provable is that this argument rests on news and sports staying inside the cable bundle. And a good deal of it is already leaving the cable bundle. Paramount+, Peacock and ESPN+ will all stream NFL games, the most popular content on TV, online going forward, leaving only Fox’s NFC contract as a pay-TV exclusive. Fox, however, just took its evening news lineup, the heart of Fox News, over to its Fox Nation streaming service so it’s a fickle friend at best.
The New England Sports Network, the key to Red Sox and Bruins fandom and the only Regional Sports Network to actually dominate an entire region instead of just a city, is now available to any Bruins/Red Sox fan without a cable subscription. Half of March Madness is outside the bundle and so is Major League Soccer, most international soccer leagues, and a good chunk of the NHL.
So even if sports and news could preserve a diminished bundle by staying put, they aren’t.
Coulda, Woulda … Shouldn’t a
For these reasons, it seems to me that, not only is pay-TV not going to stabilize at some lower subscriber level, but it’s also not going to just continue to decline at the current rate. Rather, it will cross some tipping point – I don’t know exactly what number that tipping point is – and then it will collapse swiftly. Below some critical mass point, content will begin defecting out of the bundle faster than rate hikes can replace it to keep it viable. A complete collapse in 18-24 months from the start date seems to me quite possible. I would define start date as the day either Disney (DIS) or some combination of Comcast’s NBCUniversal, Warner Bros. Discovery’s (WBD) Turner Networks or Fox Corporation (FOX) launch a DTC for their flagship channels, since they have more to lose from the bundle’s collapse than anyone else.
Alphabet Implications
I know, I know, get back to Alphabet. The significance of this is that YouTube is both the leading virtual pay-TV provider – if people actually want to replace their collapsing pay-TV system with a different one – and the leading ad-supported streaming service in the US.
Thus, a recession might take Alphabet’s revenues from pay-TV in the US to a whole other level, in two different ways. The first is simply that yes, more people might sign up for YouTube TV. And the revenue growth from a pronounced acceleration in YouTube TV could still be significant in reassuring investors that revenue and earnings growth will not be endangered by the recession, considering that YouTube generated $7.3 billion in ads last quarter worldwide while US Pay-TV generates roughly $15 billion per month in ads and subscriptions.
Of course, some might argue that there is far less profit in pay-TV than there is revenue, which is precisely why all the cable companies are in such a rush to get out. That’s true, although I’d argue YouTube TV does a better job of generating profit than traditional TV over the same revenue base. But rather than deep dive on that, let me focus on my second point. If nothing replaces the old pay-TV system, if it just collapses and takes all its existing advertising arrangements with it, then $70 billion a year in US advertising video spending is going to be looking for a new home!
Breaking Old Traditions
It would be difficult to overstate the significance of this.
While Google Search has become the global advertising powerhouse in digital terms, YouTube remains further behind in video advertising than some would expect, considering its superior capabilities. Advertisers, especially brand advertisers like that found in video, are notoriously risk averse, as YouTube already found out before to its chagrin.
And even more than risk-averse, they’re just plain old-fashioned. It often takes a shock to snap them into embracing new technologies, and US Pay-TV ad spending is still three times the size of YouTube’s global ad revenue! This despite the fact that YouTube generates almost as much viewing on Connected TV as Netflix, to say nothing of its mobile and computer viewing.
The complete collapse of Pay-TV, however, will force old-fashioned advertisers to do what the numbers say they already should have done years ago: go looking for new, digital homes.
YouTube’s Superiority Finally Shines Through
YouTube is poised to capture, not just a good chunk of it, but probably the lion’s share.
YouTube allows for far more precise targeting of advertising. It has access to Google Search data, as well as its own viewership stats, which means it can generate almost unmatched levels of precision targeting. Only Amazon and Meta can even hold a candle to it, and frankly, neither of them is probably quite in Alphabet’s class. Certainly Hulu, which generates close to if not over $1 billion per quarter in video ad spending in the US alone, despite having a fraction of YouTube’s user data and one-third of its viewership on Connected TV, shouldn’t be outperforming YouTube so. It does because it’s owned by Disney, a company traditional advertisers are familiar with and have close, old-fashioned relationships with.
It’s customary to talk of targeting capabilities as generating higher prices, but I prefer to think of them as lowering waste, by distinguishing between ads and ad slots. Greater targeting means that more irrelevant ads can be eliminated and more relevant ads stuffed into a given ad slot, a break in content of whatever length. Sending separate makeup ads and razor blade ads to a women and a man is twice as efficient as making both of them sit through the other’s ads.
This allows YouTube to generate more revenue with fewer ad breaks. This, in turn, improves the user experience and draws still more viewers to YouTube, giving them all the more leverage to capture a still greater share of content from former traditional TV advertising.
Investment Summary
YouTube TV generates one-third every month around the world of what pay-TV generates in the US. From a pure numbers perspective of capabilities, data, and ad loads, that’s ridiculous. It endures because brand advertising is notoriously slow and ponderous to follow new technology.
The end of the bundle as we know it will put an end to this and force advertisers to move to YouTube. And once they move to it, they will almost certainly find they like it and move even more money to it.
This prospect considerably eases my concerns about Alphabet’s potential slowing revenue because even if a recession knocks Google Search back on its heels, a flood of brand advertising money into YouTube and YouTube TV might keep revenue growth rates at or above current expectations anyway.
Investment Recommendation
I am honestly torn between a strong Hold and a weak Buy. Obviously, my projections about pay-TV are not shared by the broader analyst community, and a recession is a significant risk factor for any advertising-based company. But I have a strong conviction that pay-TV’s demise, which has been a long time coming given how outmaneuvered it has been by Netflix (NFLX) and company, is indeed now rapidly approaching.
But I don’t think it will hurt to wait a little longer to see if I’m right, by looking for some of the indicators I described in this article. Which the majority of the market doesn’t seem to be focusing on, so you probably won’t miss the boat to wait. For now, then, I am going to keep Alphabet a Hold. A strong Hold.
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