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Alphabet - shares drop as revenue growth disappoints

George Salmon | 30 April 2019 | A A A
Alphabet - shares drop as revenue growth disappoints

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Alphabet Inc NPV C

Sell: 2,513.15 | Buy: 2,513.93 | Change -7.67 (-0.30%)
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Alphabet delivered revenues of $36.3bn in its first quarter, around $1bn below consensus expectations.

Operating profit is slightly ahead of forecasts at $6.6bn, or $8.3bn excluding the impact of a $1.7bn EU fine for abusing its monopolistic position. However that was largely down to a lower than expected slice of revenue going in traffic acquisition costs.

The shares fell 7.3% in after-market trading.

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Our view

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

It's all about volumes. The more people use Google, the better. Same goes for YouTube, Maps and the Play Store. As we spend more time online, the option to advertise on these resources become ever more attractive to advertisers.

The group has to incentivise others to offer its products as 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 in side-projects like Waymo self-driving cars and Verily life sciences. These have the potential to bring significant profits, but are unlikely to move the dial yet.

A notable exception is Alphabet's investment in cloud networks, which use the internet to provide on demand computing power to others. This could meaningfully contribute to profits sooner rather than later.

Significant investment in the cloud means capital expenditure is rising sharply. But the success of the core business means it should still generate tens of billions in free cash flow every year.

Alphabet's cash on hand already stretches well past $100bn. It doesn't pay a dividend, so it's fair to ask what the group's going to do next. It'll be interesting to see if Alphabet steps up spending on those Other Bets, extends the buyback or pursues merger and acquisition activity.

The main worry is around regulation. The group already racked up billions in fines for anti-competitive practices, and there's some evidence the changes are impacting the day-to-day too. YouTube, which accounts for a significant portion of clicks on paid ads, is under pressure to improve accountability and saw a slowdown in ad clicks last quarter.

Still, there's plenty of potential. Alphabet says nearly half of US ad budgets are still spent offline and only around 10% of shopping is digital. To us the group looks well placed to benefit as these balances change, which underpins our confidence it can grow profits in the years ahead, provided there aren't more faux pas in the pipeline.

Prior to the price fall on the back of Q1 results, the shares traded on a price to earnings ratio of a shade under 26.

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Q1 Trading Details

Alphabet's underlying top line growth slowed to 19% year on year, driven by weaker growth in Google properties' revenues - which include search, Gmail, Maps and YouTube. The group saw a deceleration in the growth of paid clicks, up 39% year-on-year, and a 19% drop in the revenue earned from each such click. As such divisional revenue growth was $25.7bn, up 16.7%.

Other advertising revenues, which include AdSense and AdMob, moved 8.5% higher to $5bn, while the group's 'Other' division, which include Cloud and hardware sales, rose 25.1% to $5.4bn.

Other Bets revenue was $170m, with losses from these early-stage projects rising to $868m.

Excluding the EU fine, total costs rose 19.2% $28bn, driven by increased content costs around YouTube and the group's investments in new data servers. Traffic acquisition cost, R&D and staff headcount all increased too. As a result, underlying operating margins fell from 25% to 23% and underlying profit rose 8.8% to $8.3bn.

Those higher profits helped operating cash flow rise to $12bn, which after a lower capital expenditure bill of $4.6bn equates to free cash flow of $7.4bn. That ensured Alphabet ended the quarter with a net cash position of approximately $113bn.

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The author's connected parties hold shares in Alphabet.

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.

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