I was recently asked whether Alphabet (GOOG) is in our Timing the Market seasonal portfolio, given the company recently blew through its earnings estimates. The quick answer is “no,” due to reasons of seasonality. However, I wanted to give my thoughts on the company itself, essentially updating my thesis on this stock.
The first thing to mention is that Alphabet’s revenue keeps growing – like, nonstop. Usually, when a company grows at such a pace, you can expect a slowdown sometime soon. Thus, while all the analysts are hyped up due to earnings surprises, I’m looking for stagnation and a reason to short.
But, as you will see, Alphabet is an exception here. Once you dig into the company fundamentals, you’ll see that the company’s astounding growth is easily sustainable. For the sake of clarity, I’ve simplified the growth story into a list.
But before we get to that, let’s start with an earnings sentiment analysis.
Natural language processing (“NLP”) has become increasingly popular in finance over the past two decades and has led to methods that allow for us to accurately capture the sentiment in financial documents or corporate announcements. NLP applied to financial forecasting – its own research field (natural language financial forecasting, or NLFF) – has shown efficacy in predicting stock movement over medium-term time horizons.
I’ve been using my own method of NLFF over the past several years, specifically for predicting stock price movements after earnings reports (example here). In short, I run NLP over earnings call transcripts to arrive at a sentiment score. The sentiment score, which is essentially the difference between optimistic statements and pessimistic statements, scaled by the number of total statements, tends to be correlated with the coming quarter’s stock price movement.
I’ve run the analysis for GOOG, including the recent earnings call transcript. Here are the results of the sentiment score relative to the average sentiment:
44% below average
58% below average
26% above average
39% above average
22% above average
12% above average
17% above average
17% below average
20% above average
(Source: Damon Verial)
Here is sentiment against the chart of GOOG:
The chart and sentiment scores tell the same story. Sentiment drop precipitously at the beginning of the pandemic, rebounding to a sustainable ~20% above average. The stock moved with sentiment, only pulling back in the last quarter, which was predicted by the downturn in sentiment.
Based on the most recent earnings sentiment, we can expect a return to the upward trend in the coming quarter.
5 Reasons Alphabet Will Continue to Grow
Now to the meat of the story: How is it that Alphabet’s revenue just keeps growing? As a former digital marketer, I worked deep in the main industry driving Alphabet’s growth: search and video advertising. While many analysts like to point to Google Cloud or the newest Pixel launch as bullish catalysts for the stock, the fact remains that of Alphabet’s $75.3B in revenue, $43.3B of that is from search advertising; $8.6B of that is from video advertising; and $9.3B of that is from network advertising (e.g., in-app advertising). That is, the vast majority of Alphabet’s revenue is still from digital advertising, and this is where your main focus should be when predicting Alphabet’s future prospects.
What follows is a list of reasons growth is sustainable both for Alphabet and for the digital advertising industry. This is an industry that changes quickly, so be sure you stay on top of the industry standards (mostly driven by Alphabet). This list is up-to-date.
1. Earnings Per Pageview Is Increasing
Each search you make on Google results in a pageview, your viewing of the displayed page. Each pageview is quantified by earnings (or expected earnings). Earnings are driven by ads placed on the page.
Here is a pageview. I’ve added arrows to emphasize the sources of earnings for Alphabet:
Alphabet cannot reasonably add more ads to most pageviews to increase earnings and so focuses on increasing the metric of earnings per pageview. It does this via increasing the minimum bid for advertisers (the minimum earnings Alphabet obtains per click) and by optimizing the quality score (“QS”) of the ads placed on the page (essentially, the probability of a click). Alphabet is constantly tweaking these aspects to raise the expected value of a pageview’s earnings, allowing for increasing earnings even without increasing the number of ads.
2. Ad Rank Forces Bidders to Increase Bids
Remember that advertising with Google is engaging in an auction. Ad rank, Google’s algorithm for determining the placement of an ad, forces users to increase their bids. This is especially true if an advertiser’s ads are of low QS.
In other words, if Google determines an advertiser’s ad to be of low relevance or of low likely click-through-rate (“CTR”), it requires a higher bid for that ad to be placed in front of the targeted consumers. This has led to an environment in which high-volume keywords garner fierce bidding competition. It used to be that everyone bid for generic keywords because of the high volume, but the Google algorithm is now discouraging that.
QSs tend to be low for high volume keywords because of a lack of specificity, requiring higher bids. The result is that everyone has gravitated toward long-tail keywords, which previously were not very profitable for Google. It used to be that long-tail keywords were ignored due to low volume, but recent research has shown that long-tail keywords bring in high-quality leads compared to generic keywords.
So now, Google is making bank selling ads for pretty much every long-tail keyword you can imagine. While previously, long-tail keywords were unpopular due to a perception that volume is king, now they are more competitive than the high volume generic keywords due to producing leads likely to convert. For long-tail keywords, QS is generally higher, and thus bid floors are lower. Advertisers can use their budgets more efficiently by targeting long-tail keywords, and Google receives more revenue due to the newfound popularity to buy ads for long-tail keywords.
Here is an example.
Generic search, one advertisement:
Long-tail keyword, four ads – no unsponsored results above the fold.
This just shows that the idea of more competitors being the major driver of increased bids is not correct. The true revenue driver here is that the industry has shifted from competition for volume to competition for quality. Advertisers increasingly want quality leads, and Alphabet has responded appropriately with its ad display algorithm.
3. Inflation Has Established Increasing Bid Floors
Cost-per-click (“CPC”) is increasing due to inflation. While some might claim that this is not a source of real growth, the fact is that once bid floors rise, they are unlikely to fall. Keywords have pretty rigid industry-standard CPC, and if these prices rise – even if simply due to inflation – they still become “sticky” in the advertiser’s mind.
CPC has risen by over one-third over the last year. The CPC for legal ads, for example, was $5 last year but is around $7 this year. Here, $7 is a sticky number – law firms’ advertising budgets are likely to plan to spend at least $7 per click going forward, even if inflation wanes. That’s an easy source of extra revenue for Alphabet.
4. The Macro Environment Is Supportive of Alphabet’s Growth
This one might seem a bit obvious, but when the economy is good, as it is now, we can expect Alphabet’s revenue to grow. It’s simple, but it’s a fact that GOOG investors should keep in the forefront of their minds: When companies are doing well, they naturally increase their advertising budgets. More money going into digital advertising increases bid floors, thereby increasing revenue.
strong economy -> increased advertising -> more competition -> higher bid floors -> stronger earnings
As we are in a strong phase in the business cycle, we can expect the macro environment to act as a tailwind for Alphabet.
5. Google’s Environment Has Forced Brands to Advertise
The environment that Alphabet has created is one in which every brand must advertise for its own brand’s terms. Digital advertising is no longer a choice and is now a necessary expense for any branded business. That is, if you own a company called “Crow Golf Clubs,” selling golf clubs, you cannot afford to not buy ads for “Crow Golf Clubs.” The reason is that if you do not buy ads, your greatest competitor, “Hawk Golf Clubs” will buy ads for “Crow Golf Clubs.”
The problem becomes apparent once you search for “Crow Golf Clubs” and see the first result to be “Hawk Golf Clubs.” You got sniped, and anyone searching for your brand now has a competitor enticing him away. Hence, you need to be willing to buy ads for your own brand and be willing to outbid competitors to keep your brand on top.
As a bit of an aside, this applies to YouTube advertising, too. This is still a bit of a marketer’s secret, but I expect it to become mainstream in the coming years, as it is with search now. Here’s the secret: An advertiser can make a short video advertisement specifically targeting your competitor’s videos and place that advertisement as a pre-roll ad (an ad that plays before the main video) on your competitor’s video. So, although someone clicks on the video, “Why to Buy Crow Golf Clubs,” he first is welcomed by the CEO of Hawk Golf Clubs, who says, “Here are five reasons Hawk Golf Clubs are superior to Crow Golf Clubs.”
In short, Google has created an advertising environment in which sniping is possible, necessitating advertisers to buy advertisements for their own brands and search terms. Moreover, as long as a company has enough money, it can capitalize on competitors’ names and popularity via Google’s advertising platform. In this way, Google has siphoned money from traditional competitive practices (e.g., focus groups, surveys, R&D), as sniping competitor ads tends to be a better use of capital.
Sustainable Growth Wrap-up and Other Reasons
Google’s bidding options are becoming more competitive and profitable for many reasons, as listed above. I have many other reasons Google’s search advertising revenue is likely to increase, but those listed above are well-founded. Some other, more speculative reasons (as per my observations or developing trends) Google will see continued growth in its digital advertising follow.
Search ads are increasingly likely to include images, especially for product ads. Images increase CTR, which naturally results in more revenue for Alphabet. Chrome owning the browser market has led to the address bar being used for typing general terms as opposed to typing URLs. This makes brand sniping even easier, as users are more likely to access Google.com before arriving at their destinations. Ad blockers, recently being considered the harbinger of the end of search/display/video advertising, have not grown in popularity. Most people simply cannot be bothered to install an ad blocker. Moreover, the shift from PC devices to mobile devices (where ad blockers are even less common), has actually decreased the threat of ad blocking on the industry. The internet is still new to most of the world. India, for example, is quickly adopting the internet to daily life. The world still has 4B people who have yet to adopt the internet. The growth of internet users will naturally lift Alphabet’s revenue over the coming decades. Habits have changed in a way that puts a larger proportion of daily life online. Covid has helped form these habits, and they are likely to stick. More daily internet use is naturally good for Alphabet’s bottom line. If the internet were land, we could say that land is still cheap, and plenty of real estate has yet to be claimed. Specifically, many search terms result in no ads. I think, in the near future, most searches will result in ads, to Google’s benefit.
At the beginning of this article, I stated that GOOG is not in our seasonal portfolio. We invest based on three things: macro, technicals, and seasonality. The macros look great, but seasonality points to stagnation in February and March, which is why I could not recommend it as a buy at this point.
Here is the result of holding GOOG over February (seasonal) versus buy-and-hold. You expose yourself to large drawdowns without any upside reward:
March is a little better, but we still see drawdown exposure with no upside reward:
So while I cannot recommend GOOG from a seasonal perspective, it is a good stock if you’re a buy-and-holder. The best time to dollar-cost-average is in October, but April can be a good time to buy, too, if you want to get in soon. Overall, from a seasonal perspective, I say GOOG is a sell for February, a hold for March, and a Buy in April.
I hope this article has been helpful. Let me know if you have any questions.