Why Alphabet Inc (GOOGL) Stock Is Likely To Outperform In 2017

GOOGL stock is currently undervalued when compared to its peers, but that could change in 2017.

  • Alphabet stock underperformed the market by a significant margin in 2016.
  • This can be attributed to investors worrying about Google's declining margins and rising costs.
  • This might however, change once investors start focusing more on the company's growth outlook.

Alphabet Inc (NASDAQ:GOOG) stock badly underperformed the market in 2016, finishing with a modest return of just 2% vs. 11% by the S&P 500. More notably, GOOGL stock underperformed its FANG counterparts consisting of Facebook Inc (NASDAQ:FB), Amazon.com Inc (NASDAQ:AMZN), and Netflix Inc (NASDAQ:NFLX), with all but Netflix finishing the year with double-digit gains. The stock appears to have taken a breather after rallying hard - 45% over the previous 2 years.

GOOGL stock is undervalued

While GOOGL stock has underperformed, Alphabet has continued posting strong top and bottom line growth, and the shares now look undervalued. At a valuation of 10 times EBITDA versus 19.2 times for Amazon and 13.5 times for Facebook, the shares look cheaper than what the company's growth calls for, suggesting the market has not fully priced-in Google's strong growth.

According to Morgan Stanley analyst Brian Nowak, the underperformance by GOOG stock can be chalked up to Alphabet's deteriorating core margins and investors focusing on deleveraging of traffic acquisition costs. Alphabet's operating margin has fallen sharply from 35.4% in 2010 to 26.3% currently. Margins have been eroding due to falling CPCs (Cost Per Click) and rising traffic acquisition costs.

Google's Cost-Per-Click has continued declining due to the increasing exposure to international markets. More than half the company's revenue comes from international markets, where lower ad pricing and adverse effects of a strong dollar are major headwinds. Meanwhile, Google's search ads form the bulk of its revenue and command better prices than display ads on platforms like YouTube due to higher engagement rates. Unfortunately, Google's search business is becoming increasingly saturated making it harder for search CPC to improve.

Also Read: Alphabet Inc's (GOOGL) Next Growth Cycle Is Closer Than You Think

Google's increasing traffic acquisition costs, or TAC, have also been pressuring margins. TAC refers to the fees the company pays to partner websites that run Google ads. The portion of TAC that Google pays to distribution partners to make its search engine the default option on rival platforms such as the iOS on iPhones jumped 33% during the last quarter, much higher than the top line growth of 20%. Google says this trend is due to the fact that its strongest growth areas, including mobile and programmatic advertising, naturally have higher TAC.

Why these concerns are overblown

It appears as if investors have been overreacting and missing the forest for the trees. Google remains by far the most dominant ad company with good growth runways. During the past few quarters, revenue growth has been accelerating, a remarkable feat for a company its size. Indeed, Google stock has kicked off the year on a strong note after racking up gains of 4.7% in the first two weeks of trading. That's better than the 1.6% gained by the S&P 500, but worse than Facebook's 9.6%, Amazon's 6.6%, and Netflix's 5.4% over the timeframe.

Meanwhile, Google websites and new initiatives like the Pixel remain in the pink of health. Google derives 80% of its revenue from its own websites rather than partner sites. And the good news is that revenue on Google websites has consistently been growing much faster than AdSense revenue from partner sites. During the last quarter, Google websites brought in revenue of $16,089 million, up 23% Y/Y, while Google's partner revenue was $3,732 million, up a mere 1%. The huge disparity in growth rates could be the result of Google cracking down hard on low-quality sites that try to game marketers by offering search spam. But it also has a more nuanced side: Google is increasingly relying less and less on partner sites for its revenue, meaning its TAC is likely to remain under control.

Meanwhile, Pixel has been one of the company's most successful hardware innovations. Morgan Stanley estimates the company will sell ~6 million units in 2017, bringing in $4 billion in revenue and $900 million in gross profit. 6 million units pale in comparison with what Apple Inc (NASDAQ:AAPL) manages with the iPhone - more than 200 million units sold in 2016. $4 billion might also not look like much for a company with annual revenue of nearly $80 billion. Yet, the Pixel is an important part of Alphabet because it's actually the only non-search segment that's profitable. Alphabet's ''Other Bets'' have been growing too slowly, while posting huge losses and acting as a big drag on the company's bottom line. Other Bets contributed less than $800 million to the company's top line over the past 12 months, but posted a huge operating loss of nearly $4 billion.

Also Read: Is Amazon (AMZN) Becoming A Threat To Alphabet (GOOGL)?

Pixel will also give Alphabet a means to offer a more integrated and consistent Android experience to the more than 1.4 billion Android users worldwide. Pixel might not grow into the iPhone-killer it was originally hyped to become, but it's likely to lead to materially faster revenue and profit growth for Alphabet in the coming years.

The bottom line on GOOGL stock

Investors have been focusing too much on the finer details of Alphabet's growth metrics and in the process missing the bigger picture. But with the company's growth on an uptick and the shares looking significantly undervalued, it's only a matter of time before the market rewards GOOGL stock investors. With earnings projected to grow at nearly 18% in 2017, double-digit gains for Google stock might be on the cards.

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Author's Disclosures & Disclaimers:
  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
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