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Alphabet - slight miss on revenue, but click growth strong

George Salmon | 26 October 2018 | A A A
Alphabet - slight miss on revenue, but click growth strong

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Alphabet Inc NPV A

Sell: 2,837.95 | Buy: 2,838.27 | Change -72.66 (-2.50%)
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Total Q3 revenue came in at $33.7bn which, although up 22% at constant exchange rates, is marginally behind consensus forecasts.

A gain on equity investments helped net income beat forecasts, but operating profit, a figure that excludes that gain, rose a more modest 6.8% to $8.3bn, again slightly behind expectations. Profit growth was held back by higher costs, in particular the $5.2bn R&D spend.

After ending the previous day up 4.3%, the shares dipped 3.7% in after-hours trading.

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Our view

Alphabet is the parent company of Google. While its algorithms would give most maths professors a headache, Alphabet is as simple as ABC for investors.

The internet is changing the way advertising works. Appearing at the top of search lists is crucial for companies in the modern world, so customers will pay handsomely for first place in whatever search engine is most popular. Google's now so popular it's used as a verb. That's how comprehensively it's quashed the competition.

While Google has to incentivise others to be the go-to app on their devices and some revenue is paid out to web partners, in the great scheme of things not much cash is tied up in the operation. As a result, Alphabet's search business is highly profitable.

That's given Alphabet the firepower to invest heavily in a number of side-projects. Most of these are housed in 'Other Bets'. The common theme among the companies in this rather aptly named division is that they have potential to bring significant profits, but are unlikely to move the dial yet.

However, it'd be wrong to ignore the projects that don't have a search bar.

Alphabet's investments in cloud computing - which uses the internet to provide on demand computing power to others - deserve a closer look.

The success of early mover Amazon tells us why. It generated $4.3bn of operating profit on $17.5bn of cloud sales last year, and is still growing strongly.

Investing in its cloud capabilities means Alphabet's capital expenditure is rising sharply. But the success of the core business means it's still likely to generate tens of billions of dollars of free cash flow year on year.

Surplus cash will likely see the cash pile swell into the hundreds of billions soon. It doesn't pay a dividend, so it's fair to ask what Google's going to do with all that cash. But let's face it, there are worse problems.

The main worry is around regulation. Google deals with huge amounts of data, and has already been fined by the EU commission for anti-competitive practices. That brought a fine of EUR4.3bn.

But if there are no more faux pas in the pipeline, Google should be able to grow profits in the years ahead. This potential growth supports a price to earnings ratio of a shade under 24.

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Third quarter trading details

Google advertising revenue rose 20.3% to $29bn, as a 62% increase in the number of paid click offset a 28% fall in the average cost per click on Google properties. Other Google revenues, including Google Play, Maps and YouTube, rose 29.2% to $4.6bn.

Traffic acquisition costs increased in line with revenue growth, rising from $5.5bn to $6.6bn. That means they still account for 23% of advertising revenue.

Total Google operating profits came in at $9.5bn, up 10.6% from a year earlier. The rate of growth lagged the top line as a result of increased spending on cloud and datacentres, as well as higher depreciation and sales & marketing costs.

Other Bets revenue rose from $117m to $146m, and recorded an operating loss of $727m. The group confirmed the quarter saw Waymo pass 10m miles of autonomous driving tests.

Operating cash flow was $13.2bn, which after capital expenditure of $5.3bn (up from $3.5bn last year) translated to free cash flow of $7.9bn. Alphabet ended the quarter with cash and marketable securities of approximately $106bn.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.