A Wild Card for Google That Could See the Stock 'Materially Outperform' in 2020

Google's operating margin could exceed estimates in 2020, driven by its scaling cloud business, prompting one analyst to argue that the stock could have a particularly strong year.

Alphabet  (GOOGL) - Get Report shares slightly underperformed the broader U.S. market in 2019, posting a still-strong 28% gain, against the S&P 500's 29%. The stock isn't seen to be the explosive growth stock it once was, as its core search business has matured and the company's foray into other areas hasn't yet yielded significant results. 

But RBC Capital Markets analyst says there could be a surprise in the mix with Google's cloud business. In Mahaney's note on potential big tech surprises for the upcoming year, he defines a surprise as "an event that the average Internet investor thinks is highly improbable, but we believe has a reasonable chance (30%+) of occurring," he wrote. 

"Going into 2020, we could see a GOOGL margin surprise," Mahaney wrote. Analysts polled by FactSet are looking for Google's margin to climb slightly to 22% from 21.5% in 2019. The margin has consistently declined from 26% since 2016, as hardware and the largely early-stage cloud business both carry lower margins than the core search business, whose growth has decelerated. 

But "Google Cloud is likely on track to generate close to $10 billion in revenue in 2020, and at this scale this segment is much less likely to be a margin drag on GOOGL," Mahaney wrote. He noted that Amazon's Amazon Web Services saw a 20% operating margin when the segment hit $10 billion in annual revenue. Of course, Amazon and Microsoft's dominance in cloud has provided a major headwind to Google's ability to scale its own cloud business, although recently, Google's strong cloud performance has prompted analysts to tout the business as one that could move the needle for the company. 

So if Google's cloud business can grow large enough, it could require a less aggressive ramp in costs sooner rather than later. A lesser contributor to margin strength would be that "Other Bets segments will see more investment/expense rationalization." The small segment compared to Google's entire business exists for the company to take small stakes in potentially large new projects and start-ups, which typically lose money when they're young. 

Mahaney noted the tech giant's recent margin pressures have "undermined any re-rating potential for GOOGL shares," which now trade at a historically low 24 times forward earnings. 

But if Google can maintain current revenue growth estimates and expand its operating margin past expectations, Mahaney writes that "shares could materially outperform."