Alphabet, the company formerly known as Google, put up decent first-quarter 2018 results with respect to the top line, but the company is facing a rising cost and capital-spending profile. The first quarter could have been a lot better, in our opinion.
By Brian Nelson, CFA
On April 23, Alphabet (GOOG, GOOGL) reported relatively disappointing first-quarter 2018 results. Revenue advanced 23% on a constant-currency, year-over-year basis, but operating income increased at a more modest 6.6% pace, as Alphabet’s operating margin dipped 5 percentage points. Google’s advertising revenue did well in the period, and the company even trimmed its “Other Bets” operating loss, but operating income of $8.37 billion wasn’t nearly as good as we would have liked. Traffic acquisition costs continue to spike, advancing a full 2 percentage points on a year-over-year basis as a percentage of Google advertising revenue.
Furthermore, most of Alphabet’s reported earnings beat came from below-the-line items, so we can’t get too excited about the huge leap in net income on a year-over-year basis, namely the $13.33 diluted earnings-per-share mark relative to last year’s measure of $7.73. An effective tax rate that was 9 percentage points lower also helped the company’s bottom line during the first quarter of 2018 versus last year’s performance. It was a messy quarter muddied with accounting rule changes and recent tax-law implementation, and the higher traffic acquisition costs really put a damper on operating-income expansion.
It’s still early in the year, and we’re probably not as disappointed in the quarterly performance as we’re making out to be. After all, Alphabet holds $102.9 billion in total cash and cash equivalents against a meager long-term debt load of ~$4 billion, giving it a huge net cash position (a key source of intrinsic value) and tremendous financial flexibility. Net cash from operating activities advanced to $11.6 billion in the quarter, better than last year’s mark of $9.5 billion, but capital spending also spiked considerably, driving free cash flow materially lower in the quarter ($4.3 billion versus $7 billion in the prior year). We’ll be watching closely to see if these spending levels will continue through the course of 2018, but we generally don’t like it.
All in, the first quarter of 2018 wasn’t as good as it could have been, and while we don’t plan to make any changes to the weighting in Alphabet in the simulated Best Ideas Newsletter portfolio, if Alphabet continues to string together quarters like this, we’ll have to look long and hard about sticking with the idea in the newsletter portfolio. Our fair value estimate is $1,181 per share at the time of this writing.
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Brian Nelson 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.