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Alphabet - revenues rise but profits miss

Emilie Stevens, Equity Analyst | 29 April 2020 | A A A
Alphabet - revenues rise but profits miss

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Alphabet Inc NPV C

Sell: 1,416.73 | Buy: 1,417.92 | Change -1.11 (-0.08%)
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Alphabet reported revenue of $41.2bn in the first quarter, up 15% at constant exchange rates and broadly in line with market expectations.

However, both operating income and earnings per share, $8.0bn and $9.87 respectively, were weaker than analysts had expected and actually fell on an underlying basis - reflecting higher operating costs as well as a substantial increase in employee numbers.

The shares rose 8% in premarket trading.

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Our view

Alphabet is first and foremost an advertising business. When times are good companies are eager to splash the cash and get products in front of customers, but when times are hard advertising budgets are a quick and easy cost saving.

And unfortunately amid a global pandemic that's exactly what's happening, COVID-19 cost cutting measures are seeing companies take knives to advertising spending.

Google's ad revenues makes up 82% of revenues, so perhaps it's no surprise they've seen deteriorating ad revenue in March and April. That doesn't bode well for the second quarter, but beyond that the impact will depend on how big the coronavirus hit to businesses is.

However, it's important to remember Google's scale and dominant market share make it something of an internet staple. And when the ad taps turn back on, Google is in prime position. With nearly half of US ad budgets being spent offline and only around 10% of shopping done digitally there's plenty of room for growth too.

Over the years, core advertising profitability has 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 provide on demand computing power and services to others. Rapid growth means the division is making around $10bn a year in revenue. However, significant investment here means capital expenditure has risen sharply. And while many businesses are having to cut back on such spending in the current crisis, it doesn't look like Alphabet will have to.

Cash on hand stretches well past $100bn and they generated a good amount of free cash this quarter. That should help it weather the current storm with some comfort. Nonetheless the next few months could be a salient reminder that the global tech giants are not immune to the fortunes of the wider economy.

And while we don't expect Alphabet to be at the forefront of regulators minds at the moment, it's still a main worry of ours. 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.

Overall, while things look likely to get worse before better, there are still reasons to be positive. Alphabet currently trades on a PE ratio of 27, above the long run average but behind fellow cloud giants Microsoft and Amazon.

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First Quarter Results

First quarter Google advertising revenues rose 10.4% to $33.8bn. This includes an 11.6% increase in revenue from Google owned 'properties' like Google.com, Gmail, Maps and YouTube, and a 4.1% increase in Network Members' properties where Alphabet provides adverts for third party websites' advertising space.

Google Cloud revenues rose 52% to $2.8bn while Google Other (which includes the Google Play store and hardware sales) saw revenues rise 23% to $4.4bn. Revenues from 'other bets' fell 21% to $135m.

The core Google business saw operating income rise less than 1% to $9.3bn, while losses from 'other bets' rose to $1.1bn.

Total costs in the quarter were 11.6% higher than last year at $33.2bn, reflecting a significant increase in General & Administration costs which were up 37.9%. Despite this group operating margin rose to 19%, up from 18% last year.

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 8.6% in the quarter to $7.5bn. TAC as a proportion of total advertising revenue remained flat year-on-year.

Free cash flow generated by the group fell to $5.4bn in the quarter, with net cash on the balance sheet also down slightly to $112.2bn.

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