The company formerly known as Google continues to invest for long-term growth, which is impacting its operating margin and free cash flow, but the two measures remain solid, particularly the latter of the two. The company retains a level of financial flexibility that is matched by few other firms.
By Kris Rosemann
Simulated Best Ideas Newsletter portfolio idea Alphabet (GOOG, GOOGL) continues to pour resources back into its long-term growth opportunities while generating robust levels of free cash flow, but the market was disappointed with its top-line growth in the third quarter of 2018, results released October 25, despite the figure coming in at 21% on year-over-year basis. The company’s revenue growth was strong across all geographies, and mobile search led growth in Google Sites revenue thanks to a strong contribution from YouTube. Paid clicks on Google properties grew 62% from the year-ago period in the third quarter while cost-per-click on Google properties fell 28%.
Rising levels of spending at Alphabet have caught our attention of late, and the trend continued in the third quarter as its operating margin fell to 25% from 28% in the comparable period of 2017. Traffic acquisition costs, as a percentage of total advertising revenues, was roughly flat on a year-over-year basis as a favorable revenue mix shift to Google Sites from Network was offset by an increase in Google Sites traffic acquisition cost rate due in part to the ongoing shift to mobile. Other key drivers in the company’s cost of revenue growth were expenses related to data centers and content-acquisition costs, mostly at YouTube, and higher R&D expenses had the biggest impact on rising operating expenses. Increases in sales and marketing headcount and advertising investments in Cloud, Chromebooks, and Google Assistant also played a role in the operating margin contraction.
Investors should also note the impact that Alphabet’s ‘Other Bets’ segment has on its operating margin performance as it reported $117 million in revenue and an operating loss of $727 million compared to an operating loss of $650 million in the year-ago period, which suggests that core levels of profitability are much higher than the 25% company-wide operating margin suggests. Google’s operating margin was 28.2% in the third quarter, but the company continues to invest in its speculative business development segment, a move we generally like given the high profit levels and cash flow generation of its core business. Key programs in the ‘Other Bets’ segment include self-driving car project Waymo, life sciences research organization Verily, and collaborations with the likes of ResMed (RMD) and Gilead Sciences (GILD) to develop next-generation healthcare solutions in areas like sleep disorders.
Alphabet’s diluted earnings per share benefitted from a lower tax rate in the third quarter and grew to $13.06 from $9.57 in the year-ago period. The rise in net income helped drive 25% year-over year growth in free cash flow to $7.9 billion in the third quarter despite capital spending leaping 49%. Free cash flow declined less than 6% through the first three quarters of 2018 from the year-ago period to $16.9 billion as capital spending more than doubled. The company’s balance sheet remains fortress-like thanks to this robust free cash flow generation, and it finished the third quarter with $106.4 billion in cash, cash equivalents, and marketable securities compared to just under $4 billion in total debt. It also holds ~$12.7 billion in non-marketable investments, further augmenting its financial flexibility.
We continue to highlight Alphabet in the simulated Best Ideas Newsletter portfolio, and we love the company’s thirst for innovation that pairs nicely with its dominance in search. We’re watching spending closely, and the potential digital services in Europe could erode some of the recent benefits of US tax cuts. The situation is a dynamic one as the EU and UK look to devise a plan to more effectively tax big Internet firms but fear retaliation from the US. Nevertheless, we think shares look undervalued at recent prices as our fair value estimate currently sits at just over $1,500 per share.
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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.