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Alphabet has Several Avenues
to Continue its Strong Performance

Investor Advisory Service, featured Alphabet Inc. (Nasdaq: GOOG and GOOGL) (still better known as Google) one year ago when the stock was $835.37.

“The company has seen accelerating growth, and 2017 sales surpassed $110 billion. Investors have rewarded the shares with a 39% advance, and the P/E ratio has expanded slightly from 30 to 32. While not inexpensive, the company has several avenues to continue its strong performance, says Douglas Gerlach, Editor-in-Chief.

“The foundation of Alphabet is online advertising, which grew 22% in the fourth quarter 2017 and represents 85% of total sales. Within advertising, the company breaks down its results into two segments: Google Sites and Network, which make up 82% and 18% of advertising sales respectively. Google Sites includes search, both mobile and desktop, and YouTube. As the label implies, this segment generates its sales from properties that Alphabet directly owns such as its ubiquitous Google.com search engine. The continued growth of mobile computing is fueling rapid volume growth on Google Sites as paid clicks grew 48% in the fourth quarter. However, the cost per click declined 16% as advertisers demand better pricing. The company will gladly make this tradeoff as mobile search growth is expected to continue this rapid pace.

The Network segment includes websites that use Alphabet technology to implement online advertising. Paid clicks grew 13% in the fourth quarter while cost per click declined a modest 4%.

One area of concern for advertising margins is the cost of acquiring display inventory, which the company calls Traffic Acquisition Cost (TAC). TAC has been increasing faster than advertising sales and now represents a cost of about 24%, up from 22% in the fourth quarter of 2016. This increase is largely being driven by mobile search. Alphabet expects these costs to moderate in 2018.

The company does not break out sales for YouTube, but its metrics are impressive. 1.5 billion people watch videos on the site monthly and learning-related videos generate 1.0 billion views. With this type of scale, the company is experimenting with paid subscriptions and original content which includes 55 programs currently and another 20-30 more in production. YouTube is a valuable asset with great potential for further monetization.

The Google Other segment grew 38% in the fourth quarter and made up about 14% of sales. This segment includes the firm’s hardware (mainly its Pixel SmartPhone, Chromebooks, and Home Assistant devices), Cloud computing, and Play marketplace. Of these three businesses, hardware generates the lowest margins, but Alphabet feels it needs to make devices that support its Android mobile operating system. The Play marketplace supports downloadable media for its Android user base and the company gets a cut of roughly 30% of every dollar spent.

Alphabet’s Cloud service provides outsourced data center hosting for corporate customers. While the service is #3 in its industry, behind Amazon and Microsoft, it has now surpassed $1 billion in sales per quarter. The market for Cloud services is growing rapidly and there is plenty of opportunity for all three companies as corporations become more comfortable with outsourcing their data centers.

The remaining growth opportunities for Alphabet are contained within its Other Bets segment that makes up just 1% of sales. This segment includes Nest (smart home devices), Fiber (internet communications), Verily (life sciences research), and Waymo (self-driving vehicles). The company plans to combine Nest with hardware in what looks like a natural fit. Fiber is being de-emphasized and Verily is just research. However, Waymo has now surpassed 4 million miles of real-world driving and the company plans to install a fleet of vehicles as a public test in Phoenix by year end. Other Bets recorded an operating loss of $900 million in the fourth quarter and Alphabet over time has been reducing these losses.

A big risk for Alphabet comes from the actions of foreign governments. A little over half of sales come from outside the U.S. and the company has already been locked out of a large growth market, China, because of censorship. Europe is increasingly looking into Alphabet’s search practices, claiming it steers users to the firm’s services versus those of competitors, and the European Union fined the company $2.7 billion in the second quarter of 2017.

The EU fine and corporate tax reform caused Alphabet to report lower GAAP EPS in 2017 than 2016. We have adjusted 2017 EPS for these one-time items.

Analysts expect Alphabet to grow EPS at an average annual rate of 19%. We are more conservative and will project 15%. Five years of 15% EPS growth multiplied by a high P/E of 30.8 generates a potential high price of 2224. If achieved, this would represent annual compound growth of 14% for the shares.

Applying a low P/E of 22.7 to 2017’s adjusted EPS of $35.90 generates a potential low price of 815. This represents a possible loss of 30% from the current price. We model the upside/downside ratio as 3.1 to 1.

Alphabet Inc. is listed on the Nasdaq under the symbols GOOG and GOOGL. The difference is that GOOG shares are non-voting Class C stock and GOOGL shares are voting Class A stock. The non-voting GOOG shares typically trade at a small discount to the voting GOOGL shares. [Bull & Bear Comment: As we went to press, GOOG was trading at $1,072. Of the 45 analysts following the company, 36 rate GOOG a Buy, 3 Overweight and six analysts have rate it a Hold. The Average Target Price is $1,280.

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