Investors Aren't Reacting To Google's Newest Change, But They Should Be

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Google parent Alphabet (Nasdaq: GOOG ) has struggled with problems around its advertising in recent years.

First it was complaints by advertisers of placements on racist and inflammatory videos. Then some of its most popular YouTube stars were caught posting potentially racist or violent content.

YouTube cracked down last year, but the same problems have persisted. Major brands including AT&T, Verizon, Pepsi, and Walmart pulled millions of dollars from the video sharing platform until YouTube could provide assurance to the quality of the videos on which ads were being shown.

In response, YouTube shocked its creator community in April by requiring channels to have at least 10,000 views before videos could be monetized with ads. Some video creators reported as much as an 80% drop in ad revenue after the change.

YouTube again changed its revenue sharing model earlier this month in a move that could shut out many more publishers.

The policy change could have unintended consequences. Investors have yet to react to the news, but could be in for a rude awakening over the rest of the year.

The New YouTube Policy Hits Google Where It Hurts The Most
YouTube is again raising the bar on its revenue-sharing model. Starting February 20, only channels with at least 1,000 subscribers and 4,000 viewing hours over the last year will qualify for monetization. YouTube is also pledging that staff will review every single video in its Google Preferred program.

This may help to appease some advertisers, but it could have massive unintended consequences for the world’s largest video-sharing platform.

Investor reaction to the new policy has been strikingly absent, even as it’s created a firestorm among video creators. Channels with less than 1,000 subscribers account for only 7.2% of views but a much higher percentage of videos uploaded.

The change could affect Google in more ways that anyone understands.

First, creator morale is at a low, with many questioning why to even take the time to create videos. It can take years to get to 1,000 subscribers. Video creators may no longer have an incentive to grow their channel by paying for ads and may not aggressively promote their videos through other platforms.

This means fewer creators and videos, meaning less site traffic site-wide. Lower site traffic doesn’t just affect the smaller channels but will mean fewer ads shown on larger, monetized, channels as well.

YouTube is a core contributor to Google’s revenue, accounting for as much as 15% of total company sales according to Credit Suisse, and is also one of its fastest-growing segments. A speed bump in this growth will not only make it difficult for the company to meet earnings expectations but could also weaken investor sentiment.

Shares of Alphabet are already riding high on a 42% gain in 2017, but may be priced for perfection.

Analysts are expecting 6.6% earnings growth on a year-over-year basis when the company reports fourth-quarter results on February 1. The company has beaten earnings by an average of 7.1% over the last four quarters, though it did miss by 3.2% on last year’s fourth-quarter results.

Sales have jumped 22% in the first three quarters of 2017, though operating expenses have climbed at a faster 27% rate. That’s weighed on the operating margin, driving it 3% lower to 23.5% so far this year.

Cost per click, the measure of revenue Google books on its advertising, continued a multi-year decline with an 11% drop in 2016 from the prior year. This was offset by an increase in traffic and ad spots, but is a worrying trend that the company has yet to be able to slow.

Alphabet booked an effective tax rate of 19% for its fiscal year 2016 which means it might not benefit much from the lower tax rates in the United States. The company will have to recognize a massive tax bill on $60.7 billion in earnings on which it has yet to pay U.S. taxes and deferred tax assets of $157 million will need to be recalculated lower due to new tax rates.

Shares of Google trade for 35.7 times trailing earnings versus an average of 25 times over the last 10 quarters. The change to advertising policy doesn’t go into effect until late February, halfway through the first quarter. Management may get an idea of how it will affect traffic by the time it reports in April, leading to a nasty warning on the rest of the year’s results.

Is Google’s Pain Facebook’s Gain?
YouTube’s loss may benefit Facebook (Nasdaq: FB ) as creators look to other social platforms to monetize their content. Analysis by Morgan Stanley estimates that Google and Facebook grab 85% of new online advertising, meaning any loss at one platform is likely to benefit the other.

While users don’t share in Facebook ad revenue, video creators may find their message more widely received and be able to promote their own products.

Facebook also trades for a premium to the market at a price of 33 times trailing earnings, though this is actually under its 10-quarter average of 53 times.

The world’s largest social media network is still growing earnings by an average of 20% annually and is expected to post 37% year-over-year growth for the fourth-quarter on the January 31. Facebook has only missed expectations in one quarter of the last ten and has beaten them by an average of 10.4% over the last year.

Risks To Consider: YouTube has experienced solid growth and could still provide Google with the revenue it needs to meet earnings expectations even after the policy change.

Action To Take: Take profits in shares of Google or avoid buying shares until more is known about how the ad policy change will affect traffic and revenue on YouTube. Facebook may benefit as video creators seek a new platform to reach their audience.

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