Alphabet’s Ad Machine Accelerates

Advertising is Alphabet’s biggest source of revenue, including YouTube, and amounted to $206 billion in 2023, up 7.8% year-over-year. 

With such a massive top line, you would imagine the world’s largest search engine operator is In smooth sailing territory but Alphabet Inc. (NASDAQ:GOOGL) has run into a problem lately.

The key driver of growth for the past few decades, advertising revenues, has seen growth stall for some time. At least that was the belief until the most recent earnings report. 

CEO Sundar Pachai announced on his latest Wall Street call that growth in key segments had re-ignited. 

Advertising Revenue Growth Had Stalled

Google is the largest search engine on the planet and has been for a long time now. According to Oberlo, Google commands 91.6% of the overall search engine market as of February 2024.

This figure is astonishing as it stands, but two facts really emphasize its magnitude. The second ranked search engine Is Microsoft’s (NASDAQ:MSFT) Bing search, but it accounts for only 3.3% of the market. Also Google’s market share has not dipped below 90% since 2014. The search engine’s dominance extends across devices.

Alphabet’s business model has its core in effective online advertising, which consists of the flagship Search query and other Google-owned properties like Gmail and Google Play, as well as YouTube and indeed revenues from Google Network. Search is the prime revenue driver accounting for about 74% of its total ad revenue in 2023.

While shareholders have no qualms about the broad reach of Google’s operations, ad revenue growth had been stalling. Between 2020 and 2021, Google’s ad revenues increased by 42.6%. 2022 ad revenue stood at $224.47 billion, reflecting only a 7.1% year-over-year improvement. And ad revenue growth slowed down even further to 6%, reaching $237.86 billion last year.

On a quarterly basis, revenues fell from 12.6% in Q2 2022 to 6.1% a quarter later and the subsequent three quarters reported 1.0%, 2.6% and 7.1%, all of which were anemic at best. 

Paid clicks, which track user engagement and include clicks on advertisements by end-users have been fluctuating from 23% in 2021 to just 10% in 2022 and worse, 7% in 2023.

Yet the most recent quarter signaled a growth resurgence with revenues up 15.4% to $80.5 billion. That was enough to excite investors and drive GOOGL’s market capitalization above $2 trillion.

How to Get Out of This?

While shareholders were justifiably concerned when the top line slowed, Alphabet’s profitability had largely remained unaffected. There was a sharp decline in net income between 2021 and 2022, but since then, the company has recovered a lot of lost ground. 

To give a sense of just how efficient Alphabet is at converting revenues to profits, earnings before interest and taxes came in at $26 billion in the last quarter alone, up from $17 billion in the year ago quarter.

A primary catalyst in Alphabet’s top line resurgence has been its embracing of artificial intelligence. The company is putting generative AI in the hands of advertisers to better customize ads on its platform, while leveling the playing field in favor of small advertisers.

Gemini AI has not made the splash that OpenAI did when it launched but an advanced version, Gemini 1.5 was launched this year to better fanfare.

The company is experimenting with incorporating Gemini in its Search Generative Experience (SGE), reporting a 40% reduction in latency for English searches in the U.S. However, Gen AI remains somewhat conversational and poses a threat to ad clicks to its introduction has been slow.

Another factor that is set to drive growth is YouTube, almost incontrovertibly Alphabet’s best acquisition to-date given the platform’s dominance in media streaming.

As per a Nielsen report, YouTube made up 8.6% of the streaming market in January, cementing its position as a frontrunner. Furthermore, YouTube’s global viewership has reached more than 1 billion hours on average of content every single day. YouTube’s contribution in Google’s total ad revenue has remained stable at around 13%, so there remains considerable scope of expansion.

While Google was concerned about losing digital ad market share to new entrants like TikTok, YouTube has managed to adapt largely through the introduction of YouTube Shorts. And with content consumption still rising and thriving through short media content, sometimes culminating in “doomscrolling”, a further push of YouTube may be just what is needed to see ad growth accelerate further.

There is more good news for YouTube. The House of Representatives passed legislation that may ban TikTok in the U.S., if the platform’s China-based owner doesn’t sell its stake within a year. Should TikTok be banned, YouTube is a natural winner.

What Should You Do With Alphabet Stock Now?

Although slowing advertising revenue had been concerning, the recent return of 15%+ annualized growth is more than enough to suggest Alphabet continues to deserve a spot in most any portfolio. It’s especially impressive given how the firm virtually defies the Law of Large Numbers that would suggest at its scale growth rates will materially diminish.

In spite of its recent run-up, analysts continue to be bullish with a $190 per share consensus price target. It’s notable that a discounted cash flow forecast model places a more pessimistic $160 per share fair value on the stock.

Still, Alphabet trades at a relatively low price-to-earnings ratio when compared to near-term earnings growth projections. The PEG ratio of 0.56 confirms this assessment. And the P/E ratio of 25.2x is hardly elevated when compared to its peer group that averages at 29.8x.

Further bullish sentiment can be found looking at analysts, a bulk of whom have raised guidance for the upcoming quarters on the back of the most recent upbeat earnings report. 

All in all, with a fortress balance sheet that is cash-rich and a profit-and-loss statement that is looking better than it has over the past few years, it’s hard to find reasons to go against the grain. Better instead to ride this advertising train all the way.

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