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Alphabet - Other Bets dragging on margins

George Salmon | 5 February 2019 | A A A
Alphabet - Other Bets dragging on margins

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Alphabet Inc NPV C

Sell: 1,347.63 | Buy: 1,353.10 | Change -2.44 (-0.18%)
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Alphabet's gross fourth quarter revenue rose 22% to $39.3bn, helping 2018 total revenue increase 23% to $136.8bn.

Weaker margins and European Commission fines meant 2018 operating profit was flat at $26.3bn, slightly behind expectations.

The shares moved 2.3% lower 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.

As we spend more and more time online, the internet becomes an ever more important resource for advertisers. Google can offer bespoke advertising space, and controls what appears where in a search. Customers are happy to pay for that. After all, Google is so dominant in its space it's commonly used as a verb.

The group has to incentivise others to be the go-to app on their devices, and some revenue is paid out to web partners. But in the great scheme of things not much cash is tied up in the operation. As a result, the core business is highly profitable.

That's given Alphabet the firepower to invest heavily in a number of side-projects like Waymo self-driving cars. Most of these are housed in 'Other Bets' and have potential to bring significant profits, but are unlikely to move the dial yet.

A notable exception is Alphabet's investment in cloud computing. The division, housed in the Other Google segment, uses the internet to provide on demand computing power to others. Early mover Amazon generated $7.3bn of operating profit on $25.7bn 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 should still generate tens of billions in free cash flow.

Existing surplus cash, combined with the group's investments in US treasuries, already stretches into the hundreds of billions. It doesn't pay a dividend, so it's fair to ask what Google's going to do next. It'll be interesting to see if Google steps up spending on those Other Bets, extends the buyback or pursues merger and acquisition activity.

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.

Unless there are 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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Fourth quarter trading details

Google's advertising revenue rose 19.9% to $32.6bn. Traffic acquisition costs, which represents payments to hardware companies and advertising partners rose 15.3% to $7.4bn, thus falling to 23% of segment revenues.

With other Google revenues, such as cloud computing and hardware, rising 30.7% to $6.5bn, total net Google revenues rose to 23.1% to $31.7bn. Operating profit was $9.7bn, up 12.9% as cost increases saw margins fall.

Other Bets revenue increased 17.6% to $154m, but significantly higher costs saw the division report a $1.3bn operating loss.

Capital expenditure continues to rise, up 64.4% in the quarter to $7.1bn. That offset a 26.5% increase in operating cash, meaning free cash flow was unchanged from Q4 last year at $5.9bn. The group's net cash position now stands at $105bn.

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The author's connected parties hold shares in Alphabet.

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