Shares of Alphabet (NASDAQ:GOOGL), Google's parent company, have diverged from other mega cap technology stocks after the powerhouse of the digital economy reported its first quarter earnings, which disappointed. Since that late-April release, the divergence has been deepening.
After surging 24% this year, Google's stock, which closed at $1,189.55 on Friday, has dropped about 8% since missing analysts' revenue expectations on April 29, falling from its record-high of almost $1,300.
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This has occurred at the same time that other members of the marquee FAANG group, including Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), and Netflix (NASDAQ:NFLX), continue their upward momentum.
A deeper dive into Alphabet’s most recent earnings release could help explain what's making investors nervous about the company’s future growth potential.
Numbers Shrouded in Secrecy
Without doubt, Alphabet’s Q1 numbers disappointed investors in a big way. The search engine giant not only posted its slowest revenue growth since 2015, but also showed that one of its top revenue generating businesses, YouTube, is under pressure.
First-quarter revenue of $36.3 billion was roughly short by $1 billion when compared with the analyst forecasts. At the same time, per-share profit of $9.50 came in substantially lower than results for the same measure during the year-earlier period.
Perhaps the biggest negative surprise, however, which sent the stock tumbling the most since 2012, was that the weakness was broad-based across all its key financial metrics. Revenues rose 17% year-over-year, compared with 26% in last year’s first quarter, while the company’s margins dropped to 18%, compared with 25% last year.
As if all these setbacks weren't enough, Alphabet executives played an additional role in dampening investor sentiment further, by trying to wrap this poor quarter in a cloak of secrecy. Chief Financial Officer Ruth Porat made an effort to play down the analyst concerns regarding YouTube by blaming currency fluctuations and the timing of product changes for decelerating growth, without elaborating on what those changes were or why they are causing the slowdown.
In a note to investors, Nomura Instinet analyst Mark Kelley said: “This quarter will no doubt result in a reset to forward expectations, particularly for the ads business, as investors search for reasons for the fairly meaningful deceleration,” but maintained his buy rating on the stock.
As we noted out in our pre-earnings release article, Google will have a tough time keeping investors excited about its stock if the degradation in its margins continues and its executives remain tight-lipped about the company's future growth engines.
The company hasn't separately disclosed the performance of its YouTube segment nor its cloud revenue, though both businesses appear to be consuming major portions of its new spending. These units are also considered crucial for Google’s future growth, at a time when the company’s desktop ad business is declining.
Amazon Encroaching on Google Turf
Another potential threat hitting Google shares right now is the emergence of e-commerce giant Amazon as a major competitor for people wanting to search for the products they wish to purchase. Until now, Google’s search engine was the first stop for consumers looking for products and online services, but that appears to be changing.
Until now, this massive 'moat' has allowed Google's parent, Alphabet, to charge premium prices to companies and other advertisers who want to promote themselves in the digital space. But as Amazon’s e-commerce enterprise grows, and product offerings accelerate, its platform has also begun to transform into an alternate search engine.
Of additional concern for Google: Amazon’s digital advertising franchise has grown into the third largest such platform in the U.S., just behind Google and Facebook, according to estimates by EMarketer, a digital trends research firm.
While first-quarter sales, most advertising-driven, in Amazon’s “other” segment jumped 34% to $2.72 billion, Google’s growth in paid clicks slumped significantly, coming in at 39% compared to 66% and 62% in the two previous quarters. Though Amazon ad revenue is meager when compared to Google’s overall ad sales, it’s still big enough to limit the company’s future growth which of course drives the share price.
In an interview with Bloomberg TV, Porat downplayed Amazon’s threat to Alphabet's ad dominance:
"Nearly half of ad budgets in the U.S. are still spent offline. Ninety percent of commerce in the U.S. is offline and we are focused on digital playing a big role in that."
Bottom Line
Given the weak Q1 performance and lack of visibility for 2019, we see Alphabet shares continuing to remain under pressure, at least in the first half of 2109. We don’t recommend buying the stock after its 8% pullback from the record high since we believe if the macro environment worsens, the stock will be punished further and the tech sector could endure another correction.
That said, we don’t think Alphabet will go through a sustained period of weakness. Its dominance in the search engine, ad market remains hard to break. In our view, an isolated sell-off in the range of 15-20% would provide a good opportunity for anyone on the sidelines to acquire Google shares.