Google – Cloak and dagger

Google issues a closet profit warning.

• Google has effectively warned the market that 2020 is going to be rough by freezing hiring in another sign that its customers, the advertisers, have slashed spending meaning lower revenues and profits for Google.
• Sundar Pichai, CEO emailed Google employees (and the world (see here)) saying that the time has come to “significantly slow down the pace of hiring” ensuring that “Google emerges from this year at a more appropriate size and scale than we would otherwise”.
• In English, this means that advertising revenue has fallen and that in order to maintain margin, growth in costs must cease and efficiencies need to be found.
• Alphabet does not issue official earnings guidance and so it has no obligation to alert the market when things go wrong, meaning that this cloak and dagger profit warning is the best we are going to get.
• The memo also states that investments in data centres and non-business essential marketing and travel will also be looked at.
• Given, the increase in usage that Google is experiencing, it is very unlikely that it will be able to stop investing in data centres, but there are plenty of other areas where cuts can be made.
• This is a confirmation of a trend that RFM research picked up about a month ago which is why I have not been keen to exploit the fall in Alphabet’s share price.
• With everyone sitting at home, nervous about the future while the economy crashes around them, discretionary spending is falling hard.
• This means that the sellers of those goods and services will be getting little, if any, return on marketing investments and being fearful for their own liquidity, they have slashed their spending on marketing.
• This combined with a large increase in usage (which increases the advertising inventory) has caused prices for digital advertising to crash.
• Some YouTube creators have seen the number of advertisements Google is inserting on their channels increase significantly which is clearly Google trying to mitigate the fall in price with greater volume.
• In adding 20,000 employees in 2020, Google was planning on increasing total headcount by 17% and given that it has already committed to 4,000, headcount will now only increase by 3%.
• This combined with other efficiencies should put Google in a position to keep costs broadly flat in 2020.
• In Q1 and particularly Q2, I expect that revenues are going to take a hit and decline YoY.
• With Google’s largely fixed cost base, this means some degree of margin compression and potentially declining earnings.
• This should be temporary, as one of the benefits of the lockdown is a much greater awareness and usage of digital ecosystems for communication, but the days of 20% growth look to me like they are over.
• This is because the underlying global economy is in poor shape with a decline in GDP this year and an excruciating level of both corporate and government debt.
• Hence, I don’t think that the economy is going to bounce back quickly, and marketing spend by companies is something that is likely to remain under pressure for some time.
• Hence, while Google will benefit from an overall acceleration of the shift away from analogue to digital advertising, the absolute level of spending is very unlikely to come roaring back.
• Alphabet shares are trading on a forward PER of approximately 25x 2020 which I suspect is too high given the outlook for Google and the recessionary environment we are entering.
• With flat earnings in 2020, the only way that the PER of the company reaches a new level is with a decline in the share price.
• Hence, I would prefer the real beneficiaries of the lockdown which are Amazon, Microsoft and Alibaba (the cloud) if I had to have anything.