Alphabet’s top-line growth remains impressive, but rising costs continue to pressure margin performance. Free cash flow generation is still robust, which provides the backbone for its fortress-like balance sheet, but capital spending levels advanced at a significant rate in 2018.
By Kris Rosemann
Simulated Best Ideas Newsletter portfolio idea Alphabet (GOOG, GOOGL) turned in a strong finish to 2018, but rising mobile-driven traffic acquisition costs are expected to continue weighing on margin performance. Revenue at Alphabet in the fourth quarter, results released February 4, jumped 22% on a year-over-year basis as reported thanks to its continued strength in Mobile Search as well as support from YouTube, Cloud, and Desktop Search, but operating income growth came in at only ~7% as its GAAP operating margin fell to ~20.9% from 23.7% in the year-ago period.
Total cost of revenues advanced 26% on a year-over-year basis, driven by content acquisition costs for YouTube, including for advertising supported content and its new subscriptions business, the latter of which carrier higher content acquisition costs as a percentage of revenue. Costs related to data centers and hardware costs for Google and Nest family products also added to cost of revenue growth.
Total traffic acquisition costs (TAC) rose 15% on a year-over-year basis, and total traffic acquisition costs as a percentage of advertising revenue fell roughly one percentage point from the year-ago period to ~23%. The rate of year-over-year growth of its TAC, which are being driven higher by strong revenue growth in the higher TAC carrying mobile search business, has slowed since the first quarter of 2018, but the ongoing secular shift to mobile search will continue to drive TAC higher.
Management is working to optimize its operating expenses to help deal with potential gross margin pressures, but it continues to invest heavily in R&D via a continually rising headcount to support growth and innovation with engineers and product managers at Google and in its Cloud business. A growing sales and marketing headcount for Cloud and Advertising contributed to rising operating expenses, as did higher advertising investments in Search and Google Assistant. Alphabet’s ‘Other Bets’ segment continues to provide a drag on the operating line as well as it reported an operating loss of more than $1.3 billion in the fourth quarter compared to an operating loss of $748 million in the comparable period of 2017.
Nevertheless, the company is a veritable free cash flow generating machine, and management expects capital spending growth rates to moderate considerably in 2019 after nearly doubling in 2018. Despite capex jumping to more than $25.1 billion in 2018 from nearly $13.2 in 2017, free cash flow generation in the year fell by just over 4% on a year-over-year basis to $22.8 billion thanks to a 29% jump in cash flow from operations. Another robust year of free cash flow generation drove Alphabet’s net cash position even higher, as it checked in at more than $105 billion at the end of 2018 ($109.1 billion in cash and $4 billion in total debt), which does not take into consideration another ~$13.9 billion in non-marketable securities.
This tremendous free cash flow generating capacity and fortress-like balance sheet, along with Alphabet’s dominance in search and strong position in digital advertising, are core pillars of the company’s compelling story. Amazon (AMZN) continues to grab headlines with its relatively young and rapidly-growing advertising services revenue, but Alphabet and fellow simulated Best Ideas Newsletter portfolio idea Facebook (FB), which turned in 30% year-over-year revenue growth in the fourth quarter, continue to see their already substantial advertising revenues march higher at strong double-digit rates. The fourth quarter of 2018 marked Alphabet’s sixth consecutive quarter of 20%+ growth in advertising revenue, though it just made it to the mark in the period.
This is not to say that we are taking the potential for Amazon to have a more meaningful presence in the digital advertising market lightly, but we continue to be impressed by Alphabet’s ability to continually deliver 20%+ growth rates in its advertising business, which is at $130+ billion in annual run-rate revenue as of the fourth quarter. This kind of growth at such scale is nothing short of impressive, but we continue to cast a cautious eye over its rising spending levels. Our fair value estimate for shares currently sits at ~$1,500 each, and Alphabet registered a 10 on the Valuentum Buying Index in early January.
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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.