GOOGLE: Revenue Acceleration and Favorable Margins -- Pivotal Research

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Alphabet reported good 4Q16 results with better-than expected revenue growth trends alongside favorable margins. Bottom-line results came in below expectations primarily on higher than expected taxes. Overall, a higher revenue base and relatively similar margin trends in our model lead us to increase our price target slightly, now to $970. We continue to rate Alphabet Buy.

For 4Q16, Alphabet reported gross revenue growth of +22% and revenue ex-TAC growth of +23%. More impressively, on a constant currency basis the company delivered +24% growth. Advertising was, as always, the primary driver of the business, growing by +17% in the quarter and amounting for 86% of the company’s revenue. Non-advertising businesses within the Google division grew by +62% year-over-year. Our expectations and those of consensus for total revenue growth at +17% were well below what the company delivered.

Looking at expenses, despite rapid acceleration in operating costs for categories of expense such as costs of hardware, content and TAC to distribution partners, other categories such as TAC to network partners, R&D, sales & marketing and general & administrative expenses were relatively contained. Combined, the company produced margins that were higher in the quarter vs. the year-ago period (although much of the improvement was due to less spending on businesses within the “Other Bets” reporting segment). Consequently, adjusted EBITDA margins (ex-TAC) matched our expectations of 47.9%. EPS growth of +8% came in below our expectations of +13% in part because the company’s effective tax rate of 22% was higher than the 18% rate included in our model for the quarter.

As we reflect upon longer-term trends impacting the company’s core advertising business, trends seem pretty clear with Google reinforcing its co-hegemonic position alongside Facebook on an ongoing basis. Although the company calls out its expansion in mobile search, video and programmatic advertising activity as leading sources of growth (and they probably do drive some incremental revenue), we see mobile search growth as generally cannibalizing its own non-mobile search activity much as programmatic advertising cannibalizes non-programmatic sales at its display network GDN. By contrast, product innovations such as Customer Match and the establishment of marketing technology products are more critical factors helping the company grow its market share over time, and might be responsible for some of the acceleration in advertising revenue growth the company has delivered over the past year relative to prior periods. We also note that it appears YouTube is sustaining its progress in capturing share of online video while also making an increasingly plausible case for capturing traditional television budgets. This week’s news that Google would allow advertisers to buy YouTube using Google account information will likely contribute further to this trend.

Whatever the drivers, the Google’s core business benefits from scale and offers the potential to improve the efficiency of most aspects of the company’s operations. Capital expenditures are also being managed reasonably well, as evidenced by the recent retrenchment of Google Fiber. However, there are evidently factors that will hurt margins, such as rising TAC from distribution expenses. In addition, the company is expanding its consumer electronics efforts and relying heavily on marketing (including, notably, a significant amount of ‘traditional’ media) which should negatively impact margins on an ongoing basis as well, although we recognize the advantage of continuing to expand these businesses into the future.

Overall, we think the quarter should be viewed positively. As the company’s revenue base is higher than we otherwise expected, the current revenue trajectory paired with our pre-existing operating margin and tax expectations (we use a 25% rate in our model’s terminal year) leads to a higher valuation. Our new price target on a YE2017 basis is $970 vs. $960 previously. We continue to rate the stock Buy.

VALUATION. We value Alphabet on a DCF basis. Our valuation incorporates a long-term 5.5% growth rate, a short-term 8.1% discount rate and a 11.0% long-term discount rate.

RISKS. Core risks for web publishers relate to: 1) high degree of rivalry in lieu of barriers preventing competition from emerging 2) high and increasing capital needs to remain and 3) government regulations and consumer pushback related to data management and privacy.


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