Alphabet Inc (GOOG) is facing profit margin compression from rising costs. But Alphabet stock is still a good buy.
The shareholders of search giant Google's parent Alphabet Inc-C (NASDAQ:GOOG) have had a decent year so far, with the stock returning over 20% YTD. However, the recent earnings report had disappointed several investors. This was despite the fact that the Mountain View, California based company not only reported solid growth, it also beat both the top and bottom line expectations. The tech giant reported a GAAP EPS of $5.01 per share on revenue of $26.01 billion. Wall Street was expecting the company to report earnings of $4.49 per share and revenue of $25.6 billion. Google's Q2 revenue grew 21% YoY. However, in spite of the strong results, Alphabet stock fell after the earnings. So what is bothering Alphabet investors?
Google's profit margins are under pressure.
While Alphabet did report a beat on earnings, the EPS and Net Profit actually declined from the year ago period. Net Profit fell more than 27% YoY from $4.88 billion to $3.52 billion driven by the massive $2.7 billion fine imposed on the search giant by European Commission for abuse of dominant position and anti competitive activities. EPS fell from $6.02 a year ago to $5.01. However, it was not the decline in profits but rather the rising pressure on profit margins which spooked several investors. Google has seen its Traffic Acquisition Cost (TAC) rise in the last few quarters. Traffic acquisition costs are fees "which are paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services" and contributes a significant chunk of Google's cost of revenues.
In the second quarter, TAC hit a record high of $5.09 billion, an increase of $1.16 billion or over 28% YoY. It was higher than analyst estimates of $4.75 billion. The 28% growth in TAC was much higher than 21% growth in revenues, which adversely affected gross margins. Over the last five quarters, TAC as a percentage of revenue has been rising. TAC as a percentage of revenue rose from 20.76% in Q2 2016 to 22.46% in the previous quarter.
So what is driving Google's TAC higher? As we discussed, TAC consists of two parts. One involves paying network members for Ads displayed on their sites and the second involves payment to partners like Apple for making Google as a default search option on their platform. The costs involved in both these segments are rising. During the second quarter conference call CFO Ruth Porat had this to say:
"The increase in both Sites TAC as a percentage of Sites revenues, as well as Network TAC as a percentage of Network revenues, reflects the fact that our strongest growth areas, namely mobile search and programmatic, carry higher TAC.
Total TAC as a percentage of total advertising revenues was up year-over-year as a result of an increase in the Sites TAC rate, driven by the shift to mobile, which was again partially offset by a favorable revenue mix shift from Network to Sites, which carries lower TAC."
Considering that TAC is a variable cost, the rising scale of operations will not lead to any efficiency gains. In other words, TAC will rise with the rise in traffic from Google' partners.
Rising mobile traffic is creating trouble for Google.
The rising share of mobile in overall traffic is creating trouble for Google. Google saw its cost per click i.e - the amount advertisers are paying each time a user clicks on an ad served by Google, drop by 23% YoY. The drop in cost per click -was much higher than the 15 percent analysts expected, according to StreetAccount, due to more search traffic coming from mobile devices. Mobile ads cost less than desktop ads. Cost per click at Google is down for 6 quarters in a row. However, this is just one side of the story. Aggregate paid clicks were up 52% on the year and 12% on the prior quarter, driving Google's revenue higher.
More importantly, though, rising mobile traffic has resulted in Google paying increasingly higher amounts to partners such as Apple for being the default search engine on iPhone and iPad. According to analysts, Google pays out approximately 34% of its revenue from iOS search to Apple. So higher traffic from iOS is only going to drive Google's TAC higher. Analysts estimate that the total payments by Google to Apple have risen 3x from around $1 billion in 2014 to around $3 billion in 2017.
Google stock is gaining momentum, is a good buy.
So while margins are definitely a concern, Google still remains a good buy. The company is growing at a rapid pace, especially given its huge size. Profits in dollar terms are rising. According to the company, operating income excluding the EU fine rose 15 percent from a year earlier. And YouTube is delivering strong growth. "YouTube is scaling really well globally...like search," CEO Sundar Pichai had said during the conference call. Analysts and hedge funds remain bullish on the stock.
Alphabet stock is gaining momentum. During yesterday's trade Alphabet stock broke out above the 50-day and 100-day moving average resistance lines. As you can see in the chart below, the 100-day moving average was providing strong resistance to Google stock in the last couple of weeks. Yesterday's bullish crossovers indicate that Alphabet stock is likely to go up from here.
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