Alphabet, Inc. Is In A Precarious Position Ahead Of Q2 Earnings

  • Google took a disproportionate hit for its Q1 earnings miss.
  • The company cannot afford to miss estimates again, else the stock will suffer.
  • What are the key metrics to look for within their advertising segment?

Alphabet Inc (NSDQ:GOOG) will be reporting its second quarter results on Thursday, July 28 and, if recent earnings reports from other tech majors are anything to go by, investors will eagerly be looking forward to see how much of a surprise they can come up with. To put it simply, if they beat earnings estimates and revise guidance for the subsequent quarter, then the stock is set to go up; if not, it will continue the current sideways move.

Consensus earnings estimate is $8 per share, on the back of $20.76 billion in revenues, which means the market is expecting revenues to grow by 17% year-over-year from $17.7 billion reported during the second quarter of 2015 - in line with the growth rate they achieved during first quarter of this year.

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Last Quarter’s Performance and This Quarter’s Expectations

Alphabet has been growing in the above-10% and under-20% range for the last two years, and the market expectation for the second quarter is to see the company near the top end of their growth curve. Unfortunately, if they miss that expectation, the stock will likely edge lower - similar to the 6% drop Alphabet witnessed after its first quarter earnings release.

The Google parent company said it saw adjusted first-quarter earnings of $7.50 per share on $20.26 billion in revenue. Analysts expected Alphabet to report earnings of about $7.97 a share on $20.37 billion in revenue, according to a consensus estimate from Thomson Reuters.”

- CNBC

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Alphabet’s earnings are still extremely reliant on their search business and, at that size, the company can only grow at the rate at which search advertising grows. With advertising revenue being the key, transaction acquisition cost, paid clicks and cost-per-click metrics are the three most important numbers that investors need to keep an eye on.

With competition for advertising revenues coming from multiple quarters - Facebook adding advertisers by the thousands and Bing search revenue growing at double-digit rates for the last five quarters, for example - the online advertising battlefield is getting intense for Alphabet.

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A Look at Key Ad Metrics

While overall search revenues are indeed crucial to Alphabet stock’s upward movement, it’s the underlying metrics that tell the full story.

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Traffic acquisition costs are one of the core expenses that are required to be paid to third party networks. The graph above shows the gradual increase in TAC over recent years, and that puts pressure on Google to earn more per ad.

In the Q1 2016 earnings call, CFO Ruth Porat explains how their TAC was being impacted by Google’s harder push on mobile and programmatic content:

Total traffic acquisition costs were $3.8 billion, or 21% of total advertising revenue, up 13% year-over-year and down 7% sequentially. The increase in both Sites TAC and Network TAC as a percentage of revenue reflects the fact that our strongest growth areas, namely mobile and programmatic, carry higher TAC.”

As Google explores more opportunities in the mobile space, they’re naturally spending more to acquire the rights to serve ads to specific traffic sources. As mobile internet usage continues to grow, the company will inevitably need to keep spending more just to stay relevant.

Another important metric is cost-per-click, an indication of what Google earns from ad clicks.

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As you can see, they’ve been making less and less per click since Q4 2014, while the total number of paid clicks have been growing during the same period. From an advertiser’s perspective, this is a classic case of demand growing on lower price per click.

It’s a vicious cycle, if you will - as advertisers pay less on Google, the company has to keep increasing its spend to acquire even more channels on which they can serve their ads. Unfortunately, this is only sustainable for a few quarters. Unless they keep the total number of clicks moving up at the 20-30% rate, Google will start to feel the pinch of decreasing cost-per-click without commensurate increase in the total number of clicks to balance it out.

Conclusion: What to Expect

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The stock is already down 2.13% since the start of this year and, unless the company beats estimates, it will be very difficult for the company to break out of the current sideways movement.

As a long-term investor, the main metrics to watch are the three metrics I spoke about - traffic acquisition cost, cost-per-click and paid clicks. As an ad-heavy company, these are the only things that will matter when the earnings are released later this week.

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  • I do not have any business relationship with the companies mentioned in this post.
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