- Google's growth rate is accelerating due to mobile search and better positioning of mobile search ads.
- Ad pricing is the most important data point in Q1'16 earnings.
- Consensus earnings estimates still seem beatable, so expectation risk is very limited.
Alphabet Inc-C (NASDAQ:GOOG) remains best positioned among digital publishers due to the effectiveness of click-based advertising via its search engine. While Google does face stiffening competition from alternative ad-formats via social platforms, the effectiveness of search-advertising is still undisputed and is expected to grow due to improving mobile screen sizes and better positioning of ads. Google removed the right hand banner ad on its search engine and is instead selling ad units for the top 4 search results in the sponsored unit. Furthermore, Google decreased the number of search listings on each page for mobile devices, which de-cluttered the mobile search experience.
This improvement in positioning and meaningful contribution from mobile is driving sell side estimates higher. The current consensus estimate for revenue/EPS for Q1’16 is $20.3 billion and $7.95, respectively.
Mobile and core search continues to drive estimates higher
Despite the large revenue base of $49.9 billion in core search advertising, the growth rate is expected to accelerate from 10.6% to 12.7% in FY’16 according to UBS estimates. Furthermore, these estimates are pretty conservative, so there’s further upside as mobile advertising comprised 34.6% of the total search revenue mix.
Since mobile search revenue is growing at roughly a 30% to 35% annualized rate, the level of contribution from that specific product segment is driving momentum to top line numbers. Analysts are anticipating this to taper off, but that’s due to the conservative nature of long-term growth models as many analysts structure their estimates on a declining second derivative, i.e. declining rate of growth.
Mobile advertising growth will most likely sustain above consensus growth estimates as pricing increases can easily offset declining incremental penetration rates of mobile smartphones. Furthermore, Google has a near monopoly on search and aggregates the most search ad inventory, so the company has plenty of pricing leverage given its market positioning. Facebook leverages its near-monopoly in social networking to similar effect, and I view that it’s only a matter of time before CPC (cost-per-click) metrics move higher.
Google reported a 16% decline in CPC in Q4’15 and it’s been on a downward trajectory for quite a while. The reasoning for declining ad-pricing is due to mobile mix shift and excessive inventory. However, given enough time I anticipate that Google will realign its pricing to accelerate top line growth.
At least according to the prior quarter’s earning call, the management team suggested that pricing will eventually increase:
We believe this click growth is a positive indicator of ads that are proving to be more relevant to users. In other words, the CPC trend reflects the fact that the denominator's growing faster than the numerator. But we do view that as a long-term upside opportunity for both CPCs and revenue.
Investors should pay close attention to CPC metrics in Q1’16. A modest uptick in pricing will drive financial models higher.
Technical analysis, news and recent commentary
The stock continues to rip higher and is sustaining a technical up-trend despite weak investor sentiment on a broad basis in Q1’16. The stock was surprisingly less volatile than the S&P 500 in the first 3-months of the year, which suggests that there’s a lot of conviction among the investor base. The stock is above the 20, 50 and 200-day moving average, which suggests a sustained up-trend.
The Interactive Advertising Bureau, UK reported a 17.3% digital advertising growth for calendar year 2015 on April 14th 2016, which was above the expectations of third-party research firms like Magna Global, which estimated 12.2% digital advertising growth. The UK data for digital advertising is seen as a bellwether for long-term digital penetration as the UK has a 50% penetration rate for digital media spending, according to eMarketer.
The UK has the highest penetration rate for digital advertising globally, so the torrid pace of growth suggests that a mature digital ad-market can sustain healthy growth rates. Since the United States has 30% to 35% digital advertising penetration, there’s further room for sustained growth above mid-teens over the foreseeable five-years. As such, investors responded positively to UK data, as evidenced by the sudden spike on the 14th of April following the reporting of UK data.
Furthermore, a report was released today on impending EU investigation. The European Competition Commission still has concerns over the Android OS and pre-installed Google apps. We’ve seen this narrative play out with Microsoft, and quite frankly the Windows OS still comes pre-loaded with some of Microsoft’s apps. It’s dubious and unlikely that the EU can stage a strong enough case. Therefore, I don’t anticipate that this case will materially alter Google’s business practices. Google staged a strong defense with regards to anti-competitive complaints by the EU last year, so I’m fairly certain the market will discount the impact of this recent media report.
Going into earnings, analysts seem to be locking-in on their targets. This implies that there’s not going to be a significant set of revisions going into the earnings report on the 21st of April. The most recent earnings commentary received came from Wedbush Securities.
Wedbush analyst, James Dix reiterated his EPS target and neutral rating:
We keep our 2016 EPS unchanged at $34.52, while raising 2017E EPS to $40.25 from $39.71; these compare to Street estimated EPS of $34.52/$40.40. From greater 4Q15 disclosure detail, we gained some insight into Alphabet’s core and “Other Bets” margin and revenue trends. As a result of more transparency on margins by segment provided in 4Q15, we do not expect Alphabet to expand margin in 2016 at the rate it did in 2015, which saw Google business margin expand by an above-trend 300bps.
Given the consensus conservatism around expenses, I feel like EPS estimates are still beatable. I refer to the Wedbush commentary because their estimate is equivalent to the consensus. While no one is expecting the same adjusted EPS expansion witnessed in 2015, Alphabet has mentioned that they’re layering on expenses at a slower pace to remain disciplined with costs. But at the same time, they’re still going to invest heavily in data centers and offices. Typically, the amortization of server equipment composes a modest portion of all expenses for large scale web properties, so even if Capex were to tick higher, it’s not the most significant cost driver.
Therefore, the real key is whether Alphabet will rapidly increase its R&D and various other operating items.
My take: No, because there’s dis-synergies to research effectiveness beyond a certain point of investment. Adding more scientists and engineers doesn’t always equate into more research output. Alphabet’s headcount growth has decelerated from 22.2% in Q4’14 to 15.32% in Q4’15 despite accelerating revenue growth. Therefore, there’s enough evidence to suggest some operating margin expansion this year as scaling headcount has proven to be more difficult than sustaining top-line growth.
I continue to reiterate my buy recommendation.