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Alphabet - slower profit growth as costs rise

Nicholas Hyett | 29 October 2019 | A A A
Alphabet - slower profit growth as costs rise

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Alphabet Inc NPV C

Sell: 1,347.68 | Buy: 1,347.84 | Change -2.44 (-0.18%)
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Alphabet reported 22% growth in revenues during the third quarter, to $40.5bn. However, operating profits of $9.2bn rose just 6.4% and came in some way below what the market had expected.

The weakness reflects increased losses in Alphabet's Other Bets division and significant legal costs, although the core Google division performed well.

The shares fell 1.6% in afterhours 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, advertising through these platforms becomes 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 higher risk and unlikely to move the dial yet in any case.

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 here means capital expenditure is rising sharply. Fortunately the core business is more than able to meet those demands and 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, and while the group has sanctioned a significant share buyback, it's still been able to step up spending on those Other Bets or pursue acquisitions.

The main worry is around regulation. The group already racked up billions in fines, and with the Department of Justice assessing the big tech giants competitive practices, there's scope for the landscape to change.

Still, there's plenty of room for growth in the core business. 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 and that underpins our confidence it can grow profits in the years ahead, as well as a price to earnings ratio of a shade under 23.7.

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Q3 trading details

Top line growth was driven by a 19% rise in Google properties revenues, to $28.6bn. This includes both Google.com and third party search revenues, as well as other 'properties' like Gmail, Maps and YouTube. The number of paid clicks on Google properties was up 18%, although the amount earned for each of these clicks was down 2% on last year.

Google Network Members' properties revenues, where google provides adverts for third party websites' advertising space, were up 7.5%, and reached $5.3bn.

Apps, in-app purchases and digital content from the Google Play store, as well as Google Cloud and hardware sales combined to see Google Other revenue of $6.4bn, up 38.5% year-on-year. Other Bets saw revenues of $155m, compared to $146m last year, but higher costs meant losses widened to $941m.

Total costs of $31.3bn were 24.7% higher than last year. Within that, Traffic Acquisition Costs (TAC), which reflects what Google pays partners to be able to place ads on their sites, or for making Google a default search provider, rose 13.8%, to $7.5bn. Although as a proportion of total advertising revenue this was actually slightly lower than last year.

The higher TAC combined with a rise in Research & Development, and 20.9% increase in headcount, meant operating margins were 23% (2018: 26%).

Operating cash inflow of $15.5bn, coupled with capital expenditure of $6.7bn, meant free cash flow was $8.7m for the quarter. Net cash stands at $117.1bn.

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