Written by 1:00 pm EU Investment

5 Red Flags for Alphabet’s Future

Alphabet (GOOG 0.77%) (GOOGL 0.99%), the parent company of Google, is generally considered a stable long-term investment. However, it’s lost nearly 30% of its value this year as investors fret over the slowing growth of its core advertising business. Rising rates exacerbated that pressure by driving investors away from the tech sector.

Many investors will argue that Alphabet is still an evergreen investment. That might be true, but investors should still be wary of these five bright red flags that could throttle its near-term gains.

A bewildered person looks at a laptop screen.

Image source: Getty Images.

1. A new $25 billion headache

The growth of Google’s ad business, which accounted for 81% of Alphabet’s top line last quarter, decelerated over the past year. It attributes that slowdown to tough comparisons to its post-pandemic recovery in 2021 as well as the macroeconomic headwinds this year.

Period

Q2 2021

Q3 2021

Q4 2021

Q1 2022

Q2 2022

Google Advertising Revenues

$50.4B

$53.1B

$61.2B

$54.7B

$56.3B

Growth (YOY)

69%

43%

33%

22%

12%

Data source: Alphabet. YOY = Year-over-year.

Unfortunately, that slowdown could be exacerbated by two lawsuits recently filed in British and Dutch courts. Those lawsuits, which are seeking damages of up to 25 billion euros ($25.1 billion), allege that Google’s sprawling ecosystem of ad tech services grants its an unfair advantage against rival advertising platforms and publishers.

Google was hit with a 220 million euro ($221 million) fine in France last year over similar accusations, and that precedent could expose the company to much higher fines in the U.K. and Europe. It could also be forced to adjust its own advertising algorithms, as it did in France, to placate the antitrust regulators. Neither case will be resolved soon, but those risks will continue to cast a dark cloud over Google’s advertising business.

2. A $4 billion setback in Europe

Google also recently lost its appeal against an antitrust fine of about 4.3 billion euros levied by the European Commission in 2018. However, the court slightly reduced that fine to 4.1 billion euros ($4.1 billion).

The EU’s antitrust regulator initially fined Google for bundling its own first-party services — including its search engine, Chrome, Gmail, YouTube, Google Drive, and Google Play — into the Android OS. It said that practice gave it an unfair advantage against other app developers and obscured the fact that Android is still an open source OS.

Google subsequently unbundled its apps in Europe and introduced licensing fees for device makers that still wanted to pre-install them. However, it continued to appeal the fine and the ruling, which makes it easier for competitors like Microsoft to promote their competing mobile apps and services on Android devices.

3. More unresolved issues in Europe

In addition, Google was fined 2.4 billion euros ($2.4 billion) in 2017 over the preferential treatment of its shopping platform over those of other retailers, as well as 1.5 billion euros ($1.5 billion) in 2019 for preventing its third-party competitors from placing ads on its websites. The first fine was upheld last year, while the second fine is still being appealed.

All of those fines, even if they are in the process of being appealed, are reported under Alphabet’s accrued expenses and current liabilities. That’s not a big issue for a company that ended last quarter with a low debt-to-equity ratio of 0.4 and $125 billion in cash, cash equivalents, and marketable securities, but other governments could follow the EU’s example and levy similar fines against Google while crippling its ecosystem with similar restrictions.

4. New challenges in other markets

We’re already seeing those headwinds pick up in other countries. Earlier this year, India’s government launched an antitrust probe into Google’s news aggregation practices. Google’s in-app payment system, which bars developers from directing users toward other third-party payment services, has also come under fire in several countries — including Indonesia and South Korea — regarding allegations of restrictive and anticompetitive practices.

5. Rolling out new cost-cutting measures

Analysts expect Alphabet’s revenue to rise just 12% this year as its earnings dip 9%. That’s a disappointing slowdown from its 41% revenue growth and 91% earnings growth in 2021.

As Alphabet’s top-line growth decelerates, it’s reining in spending. In early September, CEO Sundar Pichai said the company needed to improve its operating efficiency by 20% to cope with the slowdown of its ad business. It’s already shut down its Pixelbook laptop business, spun off the remnants of its Project Loon internet balloon unit, and downsized its Area 120 incubator for new projects — and deeper cuts could still be ahead.

Is Alphabet’s stock still worth buying?

Despite all these challenges, I believe Alphabet is still a good long-term investment at 17 times forward earnings. It will likely need to make some compromises to deal with slowing ad sales and regulatory challenges, but we’ll still likely use its core services for decades to come. The longevity of that sticky ecosystem, along with its dominance of multiple growing markets, indicates investors should take a much longer view of Alphabet instead of worrying about the near-term speed bumps.

 

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Leo Sun has positions in Alphabet (A shares). The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), and Microsoft. The Motley Fool has a disclosure policy.

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