My underlying thesis on the stock is that Alphabet (NASDAQ:GOOGL) (GOOGL) is undervalued on a growth-at-a-reasonable price or GARP basis, relative to the general larger cap stock market (SPY) and probably even in a "normal" market with "normal" valuations.
That thesis is based on analyst consensus that shows EPS growing at nearly 20% per year for the next few years; this ignores this year's charge for the large EU fine or other future material and potential fines.
Since everyone knows what consensus is (I use E*TRADE (ETFC) data), basic financial theory says there is no alpha to be gained from buying GOOGL at a relatively low price:earnings:growth or PEG ratio. Even if the projections are correct, something is lurking to remove the prospective alpha.
So, in order to assess going long GOOGL or Alphabet's class C capital shares GOOG, a careful investor wants to judge whether there is hidden value in this company. In the rest of this article, I present data that suggests that there could well be enough hidden value in Alphabet's YouTube, or YT, division to be material to the GOOGL investor. The rationale for this article revolves around YT's large size, probably set to get larger, and what I think are important opportunities later to monetize it. Right now, growth is the YT imperative, not revenue or profit. GOOGL may be waiting until YT profits are needed to keep the EPS growth rate up to then move more aggressively to turn YT into a large, growing profit center.
Note: in this article, the symbol GOOGL refers either to the stock of Alphabet or to the whole company, Alphabet, itself. The use of the term 'Google' refers to the Google subsidiary of Alphabet, which provides almost all the parent's revenues and more than 100% of its operating profits. YouTube, or YT in this article, is part of the Google subsidiary. YT's revenues are not broken out.
Before getting to YT and its future growth, a brief comment on Google and challenges to its growth helps set the stage.
Well, no one knows, probably not even the company. In Q3, Google accounted for 99% of Alphabet's total revenues. We do not know, for example, what part of the growth was contributed by YT. This is mostly what we know, from CFO Ruth Porat's prepared remarks in the Q3 conference call. After reviewing consolidated numbers for GOOGL, she then moved to more divisional specificity:
Let me now turn to our segment financial results, starting with the Google segment. Revenues were $27.5 billion, up 23% year-over-year. In terms of the revenue detail, Google sites revenues were $19.7 billion in the quarter, up 23% year-over-year, led again by mobile search, complemented by desktop search and strong performance from YouTube.
Network revenues were $4.3 billion, up 16% year-on-year, reflecting the ongoing momentum of programmatic and AdMob. Other revenues for Google were $3.4 billion, up 40% year-over-year, fueled by cloud, play and hardware.
So, mobile led the growth in Google sites revenue; YT is a Google site. Note the careful language. Desktop search complemented mobile, with no positive modifier, but YT complemented it with "strong performance."
This is consistent with YT growing rapidly. This view is supported by a similar comment from Google.
The problem for a growth stock investor is the usual one: all growth fields slow down, even if they continue growing. And, between direct competition and pressure from regulators, extremely dominant companies face one challenge after another. So, what happens to Google when growth in ad revenue from current sources decelerates?
This article proposes that GOOGL may have two major strategies to deal with this coming threat to profits growth and therefore the stock's P/E: monetizing YT slowly until the growth path requires greater profits from it; and growing everything else. "Everything else" includes areas where neither GOOGL nor the Google subsidiary are currently dominant, including hardware; provision of Cloud services (both Google services); the Other Bets such as Waymo, Loon and the healthcare businesses Verily and Calico; and quantum computing.
But as I see it, YT is so major, "everything else" may match it at best in predictable future value.
The next sections attempt to back up a rationale for optimism that a great deal of value has already been created in YT, and that the longer that GOOGL defers realizing the value, the faster and greater lots more value can be created.
Just one preliminary time travel bit of thinking: in 1999-2000, the tech-media-telecom frenzy was reaching its zenith. There was a reason that media was part of the party then. YT is really a tech-media story, with a touch of telecom as well; though by now, we treat mobile telecom stuff as routine, not as amazing as was the case then. If one thinks like Warren Buffett, then one loves media, which unlike tech defies obsolescence.
Our digital world is doing increasingly amazing things largely because of the rapid pace of progress in semiconductor technology along with wireless technology (5G beckons). Most of us know of "Moore's Law," which states that "the number of transistors on an affordable CPU would double every two years." This was simplified to the concept that "processor speeds, or overall processing power for computers will double every two years."
Whether one uses transistor number, or resultant processing power, the concept is for about a 40% annual improvement, or about a doubling every two years.
YT may be growing at a similar or faster rate, as judged by the growth rate of videos uploaded to YT. And I think that Google is deliberately going slow on the monetization scene to drive continued rapid growth, or even hyper-growth.
Here are some data points:
Without knowing either the exact numbers or exact dates of those reports from YT, a CAGR from one number to the other cannot be figured. Taking them at face value, upload rates quadrupled in 31 months. Whether that correlated with that same increase of viewing cannot be known, but since in most free market systems, supply and demand stay in rough balance most of the time, these numbers suggest a 70% annual growth rate of viewership for YT.
That's far above the rate of Moore's Law.
My takeaway is that YT may be growing so fast that the analytic community is likely to be behind the curve in appreciating where it is going to "end up." (The quotes are there because there may be no end to YT's growth, just as the number of minutes spoken on telephones has probably grown every year for decades.)
Americans are spending over 73 minutes per day watching digital video, up more than 7 percent from last year, according to eMarketer data. TV watching has dropped 2 percent from last year to 244 minutes a day, a trend that is expected to continue.
Assuming these numbers are roughly correct, then the ratio was about 4:1 in favor of TV hours over Internet entertainment hours, excluding Internet-based audio (music, etc.) services.
That's interesting, because my point of view is that traditional TV is a dinosaur that is slowly declining.
The 4 hours a day people watch TV is low-hanging fruit for YT and its competitors. I expect massive growth of Internet video, watchable on demand and on whatever screen one wants, on a secular basis.
Next, some numbers to help put YT in perspective:
Some basic data about the world and the Internet:
This suggests that as soon as the end of 2019, 60% of the world's people could be using the Internet. That leads to a projection by the 2020-1 time frame of something approaching an 8 B world population and Internet penetration above 60%, implying 5 B Internet users.
This is the basic set-up. YT is poised to gain share in the richer countries, where TV viewing is high, from traditional TV. In fact, YT TV is growing rapidly. It is also probably poised to gain share from the many dollars spent in movie theaters. With YT, one gets full control: when to watch, what the volume is, who to watch with, etc.
Obviously, Google is a titan, but so is YT apart from Google.
As far as websites go, SimilarWeb presents Google.com as the #1 website in a recent ranking, with YouTube separate from it and #3. FB is #2.
As far as the website ranking details go, YT is #1 in minutes spent per visit, at 20 minutes spent per visit. YT also has a low (desirable) bounce rate.
Thus: YT is well-positioned from continuing expansion of people-hours spent viewing the Internet, which is likely to occur at a rapid pace for some years to come.
With all the above demonstrated, the least knowledge we have is about the numbers and types of usage for YT. Google is circumspect about it. I found one compendium of alleged details on the web that may be accurate in many respects.
Next, some additional information on YT from GOOGL:
Google's CEO added this comment about YT in his prepared remarks in the Q3 conference call:
On the community side, we are helping create meaningfully interactions that bring creators and fans closer together. This quarter, we launched a new feature that lets viewers share videos directly in the app. So the minute you see a video from a creator you love, you can share the fun with friends and family. We're also seeing significant growth in other areas.
In other words, YT, a form of social media to begin with, should be more so in Google's view. Other than YT, social media has been a core Google weakness, as you know. But at least it is trying. Look at how much it has to work with now, also per Mr. Pichai:
As I mentioned in the last earnings call, YouTube now has over 1.5 billion users. On average, these users spend 60 minutes a day on mobile. But this growth isn't just happening on desktop and mobile. YouTube now gets over 100 million hours of watch time in the living room every day, and that's up 70% in the past year alone.
In this year's Q2 conference call, Mr. Pichai had instead said that "YouTube now has 1.5 billion monthly viewers and people watch on average 60 minutes a day on their phones and tablets." So in three months, 1.5 B has moved to something above that.
Going to a yoy comparison, the number mentioned in last year's Q3 conference call was much lower:
More than 1 billion monthly users are watching hundreds of millions of hours every single day.
Whereas, in the Q2 conference call in 2016, Mr. Pichai did not mention that sort of statistic in his prepared remarks. Does that imply that YT reached the 1 B monthly viewer rate in Q3 last year? If so, then monthly viewers are rising at about a 50% yoy rate.
The growth rate of "living room" watching appears to have decelerated from last year's near-doubling yoy rate, i.e. "YouTube watch time on TV screens has nearly doubled year-on-year." In Q3, the yoy growth rate dropped to 70%.
That does not tell us how per-person engagement has gone, however.
We now know that YT has more than 1.5 B users, who on mobile alone, average one hour of use per day. Since this number is growing, 1.6 B users is either in sight or here already. Multiplying 1.6 B by 365 days per year gives 584 B yearly hours. Call it 600 B, because it is either there now or coming soon.
Then there is the question of what the number of person-hours viewing YT are on devices that Google excludes from the mobile category. Per the link above, the observation is that more than half the views come from mobile. So, if mobile is growing, and YouTube TV is certainly growing, I'm going to guess that whatever the number is for mobile, desktop gets to half of mobile. That would add, say, 300 B more person-hours, giving 900 B person-hours. Then there is the "living room" number of "over" 100 MM hours per day. I presume this is YouTube TV. This comes to perhaps 40 B hours per year.
Add it together and we get perhaps 940 B person-hours watching YT each year, based on Q3 numbers, probably those from September.
Given the rapid growth rate, by the end of this year, YT viewership may well be at or above 1 trillion person-hours per year. And growing rapidly, so far as we know.
The next question is forward-looking. Working with this 1 T person-hour annual number, which is ahead of my prior assumptions, when might YT get to 2 T?
Based on general growth of global Internet use, shift from TV and other forms of media to streaming types, and market share gains for audio-video within the Internet sector, I'm comfortable looking a few years (?) ahead to a double of wherever YT is now. One might think this is "too many" hours for just one Internet channel to win over, but look at the numbers:
When global population hits 8 B, then there will be 70 T person-hours lived per year globally. Until the rise of the Internet, the average American was spending over 20% of his or her hours in a day watching TV. So, projecting 2 T, or 3% of global hours, on YT in a few, or several years, may or may not be correct, but it sounds plausible.
Next are some guesses at a range of valuations of YT given the above estimates of YT viewing.
To value this, first, I would go forward and haircut the 2 T, but I'm not sure by how much. The haircut is mostly because some (? much) of what is viewed on YT is just listening to music with an album cover or some other placeholder on the screen, not true video entertainment. Try to monetize an old song from the Beatles or whomever you name, and you will get almost nothing from most viewers.
Then the question is, what amount can YT monetize, and at what margin.The margin question can be framed by noting that for now, YT and FB are receiving about 45% of the ad revenue from videos; the content creators get 55%. However, for YT, content that receives few views receive nothing in general, I believe, though there may be a little ad revenue that all goes to YT.
There also is or has been content that is "free" to YT, though I'm not sure of the precise current or likely future status of that content. So, I'm going to think that 50% "cost of goods" is a reasonable working assumption. That leaves 50 cents on the dollar for YT to pay all its expenses. Will expenses equal 30 cents on the revenue dollar? If so, then the pre-tax margin would be 20%. If taxes eventually take 25% of that, then the net after-tax margin would be 15%.
The next question is out of (say) 1 T reasonably high quality person-hours per year, what the economic value is to the viewers that YT can extract. The extraction process includes showing ads that produce revenue to YT; subscription fees; per-use fees if feasible; and information of value to the parent, Google, which Google uses to generate income elsewhere, such as by improving Search and its other properties.
I would think of 10 cents per person per hour as reasonable for YT to be able to extract one way or another on a global scale. Again, this is suggested to generate thought amongst you, the reader, as this is a made-up number.
Out of 1 T person hours, $0.10 per hour per viewer would translate to $100 B per year gross income to YT. At a 15% after-tax profit margin, that would give $15 B profit to YT.
What multiple would this hypothesized profit stream receive? I would think of a 20X P/E or greater profit stream, given growth possibilities and potential to monetize content viewing above the 10 cents per hour rate hypothesized above. There are ways to grow both horizontally and vertically, powered by Google's vast knowledge of the Internet and its users, and of the media. Plus, there should be growth in basic YT for years to come, given the secular trend toward the information superhighway of the Internet appearing, to me, to be unstoppable.
So, using 10 cents per hour per viewer, that would suggest at least a $300 B market cap implied for YT if and when it reaches a solid, monetizable, 1 T person-hour level. This might be achievable soon, perhaps by 2021.
Or, perhaps YT by early next decade could have an implied market value around 40% that of all classes of Alphabet stock, which is around $715 B. Of course, if one figures 15 cents per person-hour of viewing YT, or slaps a 25X or greater P/E on it, one can easily get to 50% of Alphabet's current market cap.
First, please be aware that there is a certain significant amount of speculation in this article. No guarantees! As it happens, I like GOOGL fine using current and projected sales and EPS trends; the investment point in this article is that YT could be a nice "kicker" of an asset.
Caveats understood, if the analysis above is mostly on target, it would appear that perhaps in just a few years, YT could be in a strong position to act as a strong growth driver within the Google ecosystem, picking up slack if and when profits from Search decelerate.
I find this to be a brilliant strategy assuming I am reading it correctly, because it allows YT to grow maximally at a time when Search and other existing sources of advertising revenue can carry the EPS growth burden.
This analysis, incomplete and necessarily uncertain as it is, suggests to me that GOOGL shares embody a potentially important undervalued asset, YT, within them, thus aiding the reward:risk profile of the stock.
Of course, there is much more to GOOGL than current earnings streams or YT. These include possible significant growth in business segments described above, both within Google and in the Other Bets. This article has focused on YT because it may already be the most valuable of all the "other" assets.
In summary, sooner rather than later YT may grow to be large enough to be financially material to GOOGL, and its revenue and profit potential may be somewhat hidden for now as part of Google's strategy both to manage its future profit stream as well as its stock price. Given that I view Google's current EPS stream and strong consensus projections for the next few years as attractive, I find the stock to have an attractive GARP story with the potential to provide alpha to shareholders for years to come. No guarantees, but there may be more alpha to come as the GOOGL story unfolds.
Thanks for reading and sharing any comments you wish to contribute.
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Disclosure: I am/we are long GOOGL, GOOG, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.