Alphabet reported strong revenue growth for Q4, but earnings were weighed down by lower mobile advertising margins and rising marketing expenses. Additionally, FCF margins were down as they invest heavily behind new areas of growth. Revenues for the quarter were $32.3B up 24%, which was far better than expected. Excluding a $10B tax expense on repatriation, they reported EPS of $9.70/share which was below expectations. Revenues were driven by strong growth in advertising.
Thesis intact, key takeaways:
The concern is that are making less money per click:
- Paid clicks were up 43%, but cost per click was down 14% and traffic acquisition costs (TAC) were up 33%. That put TAC at 24% of revenue, up 200bps. So, basically for their primary business, pricing is down and input costs are up, which is not a trend anyone likes to see.
- The mix shift towards lower margin mobile ads is what’s negatively impacting earnings.
- The primary cost of advertising revenue is traffic acquisition costs (TAC) and mobile search and programmatic are their highest growth areas and they have the highest TAC.
- The street is reacting very negatively to these metrics, but it’s not a surprise that mobile ads are the growth driver or that they are lower margin.
- Management has previously indicated that they expect TAC to increase as a % of revenue and that they are more focused on profit dollar growth than margins.
- Advertising growth is still very high, but as the mix increases, the lower economics of mobile become more visible.
- An added concern is that Amazon is starting to compete in mobile advertising.
- Rising content acquisition costs with YouTube and increased marketing spend to promote hardware also ate into margins.
While Alphabet is principally an advertising company, management is working hard to reduce their reliance on this business:
- They are investing heavily behind their biggest bets for the future (artificial intelligence, YouTube, hardware and cloud) which is weighing on FCF margins.
- On the call the CEO said they are “laying the foundation for the next decade as we pivot to an AI first company.”
- They differentiate themselves with their AI competency and have spent billions trying to inject AI into all aspects of their business.
- Their cloud business is progressing though they are still a distant 3rd in cloud market share behind MSFT and AMZN.
- Cloud is now a $1 billion/quarter ahead of where most analysts were estimating. AWS reported $5B in revenue for Q4.
- Their CEO says their cloud business could eclipse their advertising business long-term.
Summary of results:
Advertising – 84% of revenue, up 21% – mobile is ~47% of sales.
Other Revenue – 11% of revenue, up 38% – includes play store, cloud and hardware.
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- Hardware sales more than doubled in 2017 with strong holiday sales of home speakers and Pixel smartphones. This business carries a lower margin.
- Other Bets (1% of revenue, up 49%):
- This segment consistently runs at a loss, but losses were not as bad this quarter.
- Revenues primarily generated by Nest, Fiber and Verily.
- They paused fiber expansion in Q316, so capex from this segment was about $900m lower.
- Nest had a strong holiday.
- Waymo surpassed 4 million miles of real world driving and is the only company to have a fleet of driverless cars on public roads without anyone in the driver’s seat.
Strong across all regions:
US revenues +21%
Other Americas +31%
EMEA +24%
APAC +30%
Valuation:
FCF for the quarter was $6B and $24B for the year. This is a decline from 2017, and represents a 22% FCF margin, below their typical range of 24-25%.
- Trading at a 3% FCF yield. This valuation relies on Alphabet continuing robust top line growth and maintaining their FCF margin.
- $102B in cash, $140/share or 12.5% of their market cap.
Thesis on Alphabet:
- Online advertising’s share of overall Ad budgets will continue to grow as:
- People spend more time on the internet/mobile internet vs tv, radio, newspapers etc
- Higher ROI (+ easier to measure) per marketing dollar spent online vs other ad mediums
- They are the global leader in search.
- Well positioned to benefit from increased smartphone penetration.
- Flexible business model provides operating leverage with high returns (ROIC 50%) and huge free cash flow generation.