Alphabet's shrinking margins spooked Wall Street, but analysts look towards its future beyond ads

Key Points
  • After Alphabet reported its Q4 earnings, Wall Street was wary of the company's slimming margins.
  • While the advertising business still shows strong growth, analysts are increasingly thinking about future, non-ad opportunities like cloud, hardware, and self-driving cars
Google CEO Sundar Pichai speaks during Digital Unlocked Google event at Taj palace on Jan. 4, 2017, in New Delhi, India.
Pradeep Gaur | Mint | Getty Images

Wall Street winced when Alphabet missed earnings expectations in the fourth quarter, but analysts remain hopeful about non-advertising opportunities like cloud, hardware, and self-driving cars.

Alphabet's Q4 earnings report revealed that it is still very much an advertising company.. However, a continuing drop in ad rates and an increase in traffic acquisition costs (TAC) -- which is how much Google pays to hardware makers like Apple to use its search product -- are shrinking margins.

Although Google's advertising business is still growing, investors know that that growth won't last forever and are leery of any signs of weakness, sending the stock down nearly 5% amid a broader market sell-off.

However, Alphabet also delivered several bright spots, including a first look at the revenue for its cloud business and assurances that YouTube's child exploitation scandal didn't significantly hurt its advertising growth.

Alphabet executives refer to cloud, hardware, and YouTube as its medium and long-term businesses, while it sees its "Other Bets," like healthcare company Verily and self-driving car unit Waymo, as even longer-term opportunities.

Here are some excerpts of what analysts wrote in their notes to clients after the report:


The bottom line is that GOOG's core advertising business is well over a $100bn run-rate cash machine. It will slow. The company is determined to grow Cloud, hardware, YouTube, and other emerging businesses. It will take significant investment to see these businesses reach a scale that matters for GOOG and margins will be structurally lower than search. Still, there is meaningful potential for these as well as the Other Bets such as Waymo.

KeyBanc Capital Markets:

We would take advantage of any pullback and buy GOOGL. Alphabet's advertising business continues to grow at a remarkable pace despite its heft, and we see large incremental growth opportunities in YouTube, cloud, Maps, and Waymo.


TAC is set to moderate significantly by mid-2018, GCP is scaling quickly in an accelerating cloud environment, YouTube is seeing continued strength as advertisers migrate TV budgets to digital, and Other Bets is showing increasing commercialization. This is atop a Search story that continues to evade the law of large numbers.


Alphabet continues to drive growth at scale through strength in mobile search, YouTube, and programmatic advertising, while investing in other key initiatives (cloud, hardware, AI) that should serve as growth levers in 2018 and beyond. We are Hold rated on shares however given current valuation relative to historical ranges and highlight some potential longer-term concerns including: Amazon as the first entry point to product search; Google Cloud Platform market share; regulatory risk.


Despite strong Google Properties growth, Alphabet shares declined 2.3% in after-hour trading on profitability concerns given lower gross and operating margin than expected. But with continued strength in its core search business across both desktop and mobile, YouTube, Programmatic, AdMob, and the potential around Waymo and other "Bets", we are raising our price target to $1,275 based on ~27x our 2019 GAAP EPS projection of $47.37

Atlantic Equities:

TAC pressures continue to grow and this was augmented in Q4 by meaningful rises in other cost of revenue and sales & marketing expense as Alphabet invests behind cloud, hardware, YouTube and its other bets (eg Waymo, Nest, Verily). To some extent, we believe Alphabet's investment is a function of it needing to keep pace with Amazon, which has much greater flexibility to invest given much faster gross profit growth. Google needs to invest in hardware to combat Amazon's competitive threat in voice, its cloud business is well behind AWS in terms of breadth of services and all of the major tech platforms are investing aggressively in video. However, these areas can also all be viewed as major long term opportunities for Alphabet and although all are currently likely loss making, we believe they have the potential to be robust sources of profitability longer term.