Alphabet (Buy, $1,025 PO)

Alphabet (Buy, $1,025 PO) Stock view: Expect solid 1Q revs., but loss of non-GAAP reconciliation a concern New concerns have been raised on the YouTube advertiser pullback, but with the cuts in spending surfacing primarily in the back half of March, we anticipate only modest impact to 1Q revenue, with more significant potential impact to 2Q17 (see Advertiser boycott raising concerns on 10/20 revenues). Looking beyond the YouTube issues, our early 1Q ad checks were mostly positive, with Merkle highlighting modest revenue growth acceleration, better than the 7Obps of ex-FX Website revenue deceleration in 1Q17 (vs 4Q16) we’ve assumed in our model. Overall, we expect in-line to slightly better 1Q results driven by mobile and PLA strength (and perhaps some maps ads), but see risk of moderate Street estimate cuts for 2Q/3Q revenue on YouTube concerns. For most companies, we would expect management to help clear up the advertiser controversy on the call with some added financial disclosure or guidance, but predicting what Alphabet will say on the topic is more difficult. 1Q results will be the first quarter that Google reports GAAP EPS without a non-GAAP EPS reconciliation. With higher than usual SBC in 1Q due to changes in grant timing, it is possible Google misses Street GAAP EPS. We are leaving our revenue unchanged but lowering GAAP EPS to $7.26 from $7.36 based on higher SBC. Also, unusual charges are more likely to be controversial for Google without a non-GAAP EPS reconciliation. Core margins remain a key focus, as has been the case since 3Q16 when core Google non-GAAP operating margins contracted 95bps y/y. We expect core margins to remain down y/y driven primarily by segment mix, and our model assumes 2017 core margins are down 50bps in 2017 (to 46.1%) and another 20bps in 2018 (to 45.9%). For 1Q17, we assume 45.8% core Google non-GAAP operating margin, up 30bps q/q and down 75bps y/y. Our recent deep dive analysis suggests segment mix alone drives a natural 220bps margin headwind, which we think can be partially offset with 1) upside in high margin search growth from monetization growth (clicks and pricing); 2) leverage in individual segments from scale; and 3) cost cutting measures across the business (see Digging into the Alphabet revenue mix and margin drivers). We continue to like the stock, but recognize that potential estimate trimming on YouTube concerns, further margin contraction, SBC pressure on GAAP EPS and challenging 2Q17 comps could continue to drag on near-term sentiment. Looking ahead, we are optimistic on 2H17 based on the potential for new ad format ramps, easing comps, and potential YouTube relief (we assume the advertiser boycott eases exiting 2Q). Alphabet trades at 22x GAAP (17x ex-Other Bets, cash), in-line with the S&P and in-line to below the 5-year average (23.5x), which we view as attractive. Key theme/metric(s) for 1Q: Website growth, core margins We believe the key metrics for the quarter will be ex-FX Website growth and core margins. For ex-FX website growth, we currently model 7Obps of deceleration in 1Q17 (vs 4Q16}, and we think deceleration could persist through 2Q17, after which the y/y growth comps ease considerably. Bankof America Merrill Lynch Internet/e-Commerce | 06 April2017 =—-11 HOUSE_OVERSIGHT_014897