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Keeping a Closer Eye on Content Is Going to Cost Alphabet

By Jamal Carnette, CFA - Feb 17, 2018 at 1:35PM

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For Alphabet, being big has its costs.

Digital marketing has hit a few bumps, with Alphabet's (GOOGL -2.45%) (GOOG -2.57%) YouTube in particular taking some lumps. In March last year, PepsiCo, Starbucks and General Motors pulled ads from the video-hosting service after concerns about the site's inability to root out hate speech. In November, Adidas and HP joined the early companies amid concerns their ads appeared next to pictures of exploited children. Most recently, Unilever is saying it might yank digital advertising if the platforms don't do more to combat "fake news, hate speech and divisive content," according to The Wall Street Journal.

The pressure is mounting and Alphabet last month announced a major change for its curated Google Preferred content at YouTube, replacing algorithms with human reviewers to improve the marketing experience for brands paying money to appear during this content.

The inability of Alphabet to effectively police its host of properties is a risk investors have to consider.

Friends watching videos on a smartphone

Image source: Getty Images.

This will not be easy

Research company eMarketer estimates that in 2018 Alphabet will take approximately 42% of all net digital ad revenue, or $40 billion, excluding traffic acquisition costs (TAC) paid to partner sites.. YouTube alone is estimated to gross approximately $4.43 billion in digital ad revenue this year, which is more than the third-largest digital marketing company, Microsoft.

Alphabet has built powerful data-collection tools and algorithms to serve the advertisers who are its customers. However, it spent less time developing tools to root out questionable content. More recently, the company has stepped up on this front, using machine learning and artificial intelligence to police non-Preferred content, which is roughly 95% of YouTube channels, and announcing the human monitoring of Preferred content.

Figuring out how to best keep an eye on content has been front and center in the news lately. Major social media sites were called to testify to the U.S. Senate amid allegations that they helped Russians spread propaganda during the 2016 presidential election, and according to testimony, they've made advancements in identifying extremist content.

This month, YouTube suspended advertising on Logan Paul's YouTube channels, telling NPR in a statement that "We believe he has exhibited a pattern of behavior in his videos that makes his channel not only unsuitable for advertisers, but also potentially damaging to the broader creator community" [emphasis added.] Paul is a controversial vlogger and the latest video under scrutiny included him using a Taser on dead rats.

Here's where investors should pay attention

Not only is taking on unwanted content going to be difficult, it will also, most likely, be expensive. The first cost is direct: hiring and paying more employees to police videos on YouTube and to build and update AI algorithms to continue to identify harmful content. Investors should expect this to be reflected in Google's "other costs" line item:

Metric 2015 2016 2017 Annualized Growth
Ad revenue $67.39 billion $79.38 billion $95.38 billion 19.0%
TAC $14.34 billion $16.79 billion $21.67 billion 22.9%
Other costs $13.82 billion $18.35 billion $23.91 billion 31.5%
Total costs $28.16 billion $35.14 billion $45.58 billion 27.2%

Data source: Alphabet's 2017 10-K filing. TAC = traffic acquisition costs.

As the table above shows, in the last two years "other costs" have increased 31.5% per year, while advertising revenue has grown only 19%. Although it's prudent to note that other costs include a host of expenses, of which labor costs are only a portion, investors should monitor this figure and seek further clarification from management to find out what goes into it.

The second, less direct way to fight problematic news sources and other questionable content is to prioritize traffic results to and from more reputable sites; this could increase TAC. (News Corp. Chairman Rupert Murdoch has argued that traffic referrals from "trusted" and less "scurrilous" sources should be compensated more, with a fee "similar to cable companies.") TAC has grown approximately 30% over the last two years, a key reason for Alphabet's post-earnings sell-off.

While most advertiser complaints have been confined to YouTube, Alphabet's inability to root out questionable content has not. Google search has also come under fire for racist and sexist autocompletes and biased, hate-filled results.

The company employs some of the smartest people on the planet, and I do expect they will be able to improve the marketing experience. But from a cost standpoint, it could be a bumpy road in the interim.

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