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No hiding for Alphabet from the digital advertising slump

The Times

Try as it might to talk up future-facing bets on cloud computing and self-driving cars, investors see Alphabet as one thing — a proxy for the global digital advertising industry. That’s unfortunate at a time of soaring inflation and heightened pressure on corporate budgets.

The more dramatic slowdown in revenue in the Google parent’s third quarter is an omen for even harsher trading conditions to come for advertising-reliant technology companies such as Alphabet and Meta Platforms, which owns Facebook.

The pace of revenue growth fell back to 6 per cent in the three months to the end of September, less than half the rate in the second quarter and far weaker than the 41 per cent boom in revenue growth over the same period last year. Save for a brief contraction at the start of the pandemic, that was the lowest growth recorded in almost a decade and was behind analysts’ expectations of just over 8 per cent.

Investors were already cautious. An enterprise value of just over 11 times forecast earnings before taxes and other charges not only is down from a multiple of 14.5 at the start of this year but also is justifiably below the group’s long-running average.

Alphabet, which generates just over 80 per cent of its revenue from online advertising via its search engine, YouTube and Google Play, is battling a tightening in marketing budgets from more squeezed companies, tough annual comparisons and a rising dollar that is pushing up costs. None of those challenges will dissipate soon.

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The fourth quarter of last year, when Alphabet recorded 32 per cent annual revenue growth, represents a tough benchmark. Many economists expect the United States, which accounts for almost half of Alphabet’s revenue, to tip into recession next year. The stronger dollar wiped five percentage points — after hedging — from revenue growth during the third quarter, which will worsen during the final three months of the year, according to Ruth Porat, Alphabet’s finance chief. Having a cost base, including its research and development, that is predominantly in America means dollar strength has an even greater impact on profits.

Analysts at Barclays have forecast earnings of 5.62 cents a share this year and another annual decline to 5.02 cents next year.

The focus now should be on how Alphabet navigates the prospect of more anaemic revenue growth next year, when inflation is expected to peak. Analysts at JP Morgan expect headcount growth to slow to about 5 per cent next year, equivalent to roughly 9,000 staff and a marked slowdown from the 34,000 hires, or 22 per cent annual increase, expected this year.

The technology powerhouse’s influence is vast. It owns the world’s leading search engine, the Android smartphone operating system and YouTube, the video platform. In the longer term, that gives Alphabet an edge over Meta and Snap, its rivals competing for marketing dollars.

Efforts to mine a greater variety of seams for revenue growth might seem more pertinent than ever. Targets for spending include the cloud computing business, now the third largest player behind Amazon and Microsoft. But, given the latter’s warning of a marked slowdown in its cloud computing business, that might not prove to be the life raft that Alphabet hopes for in the near term. The business is still lossmaking, at $699 million, despite revenue rising by 38 per cent in the third quarter. These side-bets are capital-guzzlers, but the company has a rich cash pile at its advantage.

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The shares will flounder until there are solid indications of brighter economic conditions.

ADVICE Hold
WHY
Advertising spending could tighten further and a strong dollar will dampen margins

WPP

Persuading the market that advertising spending isn’t going to fall off a cliff amid a global economic slowdown is not an argument that Mark Read, the WPP boss, is winning. Full-year revenue guidance has been raised for the third time since April, but what was investors’ reaction? Shave another 1 per cent off the marketing group’s valuation.

The shares are now priced at just over seven times forward earnings, closing in on the low recorded on the back of the March 2020 stock market crash. The brakes haven’t been applied yet. Underlying revenue growth in the third quarter was ahead of consensus at 3.8 per cent, a higher increase against 2019 levels than the previous two quarters.

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Next year will be tougher, Read concedes. WPP has been trying to increase its non-advertising revenue, which accounts for just over a quarter of the group’s total, to 40 per cent in the next five years. But it is heavily reliant on ad budgets, an obvious place to start cutting spending by companies under the cosh.

Rampant inflation makes a likely slowdown in revenue growth more of a problem. Guidance for operating margin growth this year has diminished to between 30 and 50 basis points, compared with an increase of “around 50 basis points” previously flagged up. That’s even when the benefit derived from a stronger dollar is considered. The company is done with deleveraging and expects net debt by the end of this year to equate to between 1.3 and 1.4 times adjusted earnings, below a target range of 1.5 to 1.75.

Given WPP’s lowly share price, more buybacks could be on the table, after share purchases worth £735 million were completed during the first nine months of the year. So, too, could acquisitions, with ecommerce, data analytics and expansion in the United States the most desirable areas for mergers and acquisitions.

The final three months of the year, typically WPP’s busiest, will provide a clear picture of how resilient advertising revenue might be. For now, the marketing powerhouse deserves its lower rating from investors.

ADVICE Hold
WHY
Lower valuation is justified by a tougher trading environment next year

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