Simulated Best Ideas Newsletter portfolio idea Alphabet continued its impressive top-line expansion in its second quarter of 2018, but we’re keeping a close eye on growing cost and capital spending levels. A massive ~$5.1 billion fine from the European Commission also impacted reported results in the period.
[Update: Subsequent to the publishing of this article, on July 26, we raised our fair value estimate of Alphabet to $1,543.]
By Kris Rosemann
Google parent company Alphabet (GOOG, GOOGL) reported ongoing top-line strength in its second quarter report, released July 23, as reported revenue advanced 26% on a year-over-year basis thanks in part to a 58% jump in paid clicks on Google properties from the year-ago period. However, the second quarter was marked by a massive ~$5.1 billion fine from the European Commission related to restrictive licensing practices. The penalties set a record for monetary antitrust discipline, and weighed materially on Alphabet’s GAAP operating margin in the period, which fell to 9% from 16% in the comparable period of 2017.
Though a probe into online advertising contracts has yet to be completed, Europe’s disciplinary actions against Alphabet are likely non-recurring in nature. When backing out fines in each of the past two second quarters, the company’s adjusted operating margin comes in at 24.1% for the 2018 period and 26.4% from the prior-year period. Adjusted operating income, adjusting only for the aforementioned fines, advanced nearly 15% on a year-over-year basis, falling well short of the pace of top-line growth in the quarter. We’re casting an increasingly cautious eye on Alphabet’s growing spending levels, “Alphabet May Need to Clean Up Its Spending.”
In addition to operating margin contraction, the company’s total traffic acquisition costs (TACs) as a percentage of Google advertising revenues continues to climb, rising one percentage point in the second quarter of 2018, and this helped drive Alphabet’s total cost of revenue 34% higher than the comparable period of 2017. Data center related expenses, hardware-related costs, and reallocation of certain operating and content acquisition costs at YouTube all weighed on gross margin performance, which fell to ~57.5% in the period from ~60% in the year-ago period. TACs were impacted by changes in partner agreements and the ongoing shift to mobile, which carries higher TACs. Alphabet’s ‘Other Bets’ segment operating loss also provided a drag on profitability in the period (diluted earnings per share fell to $4.54 from $5.01), as its operating loss widened to $732 million from $633 million a year earlier.
Alphabet’s growing spending levels continue on its cash flow statement, which revealed a nearly doubling of capital expenditures in the second quarter from the year-ago period. Nevertheless, strength in cash provided by operating activities drove free cash flow generation to just under $4.7 billion in the quarter from ~$4.6 billion in the comparable period of 2017. The company’s fortress-like balance sheet remains very much in place as it held a $98.3 billion net cash position, giving it tremendous financial flexibility (not to mention a source of intrinsic value) as it continues to pursue innovation.
We’re going to maintain our highlighting of Alphabet in the simulated Best Ideas Newsletter portfolio thanks to its cash-rich business that dominates the Internet search space, its established and growing video platform in YouTube, and capacity to continue working to bring next-generation innovation to consumers. We’re keeping an increasingly cautious eye on its spending levels, however, on both the income and cash flow statements. While we note the obvious short-term implications of a potentially changing cost structure due to ongoing expenses and investments in new and growing technology such as data center and mobile search enhancement, we also recognize Alphabet’s thirst for innovation, which will necessitate ongoing investment for it to retain strong positioning in its markets over the long haul. We currently value shares at $1,322 each.
[Update: Subsequent to the publishing of this article, on July 26, we raised our fair value estimate of Alphabet to $1,543.]
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.