Alphabet (GOOGL) Shareholders Left Wanting After First-Quarter Earnings

While Google's parent beat Wall Street estimates, the uninspiring Q1 report should have shareholders on edge

It wasn’t a ‘bad’ first-quarter report, per se. Internet juggernaut Alphabet (GOOG, GOOGL), parent company of Google, managed to beat both earnings and revenue estimates, and logged yet another quarter of sales and profit growth that most other companies would envy.

But there’s something increasingly missing from Alphabet’s quarterly numbers: inspiration.

Alphabet still is a steamroller that no other web company wants to stand in front of. However, in an environment where the internet is changing in rapid-fire fashion, Alphabet doesn’t give the impression that it’s adapting as quickly as the market itself is. The Alphabet of today looks a little too much like the Alphabet (well, Google) of 10 years ago where it counts the most – on the internet advertising front.

If the regulatory changes presumed to be en route get here anytime in the foreseeable future, then, Alphabet might not be able to adjust as quickly as GOOGL shareholders would like to think it can.

Alphabet Q1 2018 Earnings Recap

For the quarter ending in March, Alphabet turned $31.1 billion in revenue into GAAP profits of $13.33 per share. The top line was up 26% year-over-year, and thanks to some fortuitous accounting changes, the company’s bottom line improved a whopping 72% from last year’s $7.73 per share.

Take that profit with a small grain of salt. After stripping out one-time gains, Alphabet earned $9.93 per share – still enough to beat analysts’ expectations of $9.33 per share. Those same analysts were projecting revenues of $24.26 billion after stripping out traffic acquisition costs (TAC), and sales of $30.3 billion while leaving TAC in.

Operating income – arguably the most important measure for this complicated company – grew from $6.6 billion to $7.0 billion. However, GAAP expenses grew by 33%, outpacing revenue growth and leaving investors with as many questions as answers.

Drilling Down

This earnings report looked quite different than any other that Alphabet had posted though. Namely, its Nest smart-home arm is no longer part of “Other Bets,” as it graduated to becoming part of the Google division. Without Nest’s contribution and cost in the mix, the company’s Other Bets’ operating loss narrowed from $703 million to $571 million on $150 million in revenue. Doing some back-of-the-napkin math, Nest had an operating loss of $621 million on $726 million in revenues last year.

The “Google Other” segment, which encompasses access to Google’s cloud services, apps and hardware like the Pixel smartphone generated $4.35 billion in revenue, up 36% from Q1 2017.

Alphabet also switched from citing its cost-per-click metric for its network properties (partners) to cost-per-impression measures, which better reflects how advertisers measure their advertising costs by using the company’s platform. The first entry in that column wasn’t overly impressive. Impressions were flat year-over-year, and only up 5% sequentially. Cost-per-impressions fell 10% sequentially, but grew 18% year-over-year.

Internet advertising continues to be the company’s cash cow, with its YouTube property and mobile search doing heavy lifting.

For the first quarter, aggregate clicks grew 55% year-over-year, versus an 18% decline in prices achieved per click. Sequentially, clicks grew 11% from Q4’s total, and prices per click fell 9%. The metrics suggest the per-click landscape is stabilizing.

Traffic acquisition costs, meanwhile, continue to creep higher as more people gravitate toward mobile search and away from desktops and laptops. TAC rolled in at 24% of revenue last quarter, up from 22% in the first quarter of 2017.

Perhaps most noteworthy is how Alphabet has started to factor in unrealized gains or losses on investments on the income statement.

Its stake in Uber, for instance, is the item of most interest that can now be scrutinized under this new rule. Alphabet booked a one-time $3.0 billion gain on its equity holdings last quarter, accounting for the bulk of the $3.5 billion in “other income and expenses” that totaled only $251 million in income for the same quarter a year earlier. That added $3.40 worth of earnings to the per-share profit total. Most of that amount is presumed to be attributable to Alphabet’s stake in the aforementioned Uber.

The detailed numbers outside of Alphabet’s core advertising business were anything but inspiring. That resulted in GOOGL shares trading flat with Monday’s closing price following the post-bell release of the Q1 report.

The Rules Are Changing

The adoption of new accounting standards and shifts in the most important “click” metrics spurred a different kind of earnings report from Alphabet, even bigger, more subjective changes may be afoot.

GOOGL shareholders can thank Facebook (FB) for the shift.

Facebook’s Cambridge Analytica scandal superficially took aim at the social media giant and CEO Mark Zuckerberg, but in many regards they were proxies for a wide sliver of consumer-technology companies that collect a great deal of data on users of its products. Any new regulations intended to prevent the social networking giant from gathering information that isn’t explicitly permitted by its customers likely also would apply to the likes of (AMZN), Alphabet’s Google and other comparable outfits.

And as RBC Capital Markets analyst Mark Mahaney recently penned, “Based on numerous discussions with investors, we believe the market may be underappreciating the regulatory risk facing Alphabet.”

It’s a particular concern because Google likely garners more data on individuals than Facebook does.

But it’s not clear what sort of regulations – if any – are in development in the United States at this time. In the same sense that Facebook as apt to rein in its own aggressive data-collection practices before a regulatory body gets around to it, Google may also be pressured to do the same. That would, by design, make it tougher to generate click-driven revenue in an environment where that’s getting more difficult to do anyway. Even so, by making its own rules rather than letting a body like Congress or the FTC create a new privacy standard, the new standard still could remain quite Google-friendly.

Across the pond, however, the picture is a little clearer … and a little less friendly.

The European Union will begin to enforce its new General Data Protection Regulation (GDPR) rules in May, and SunTrust analyst Youssef Squali was concerned even if abstract about the possible headwind heightened privacy rules could create. He explained of the matter before Alphabet’s earnings report was posted, “Management has already stated that it will be ready to comply across all its services with GDPR once it goes into effect, but concerns remain as to what impact these changes will have on users and marketers engagement over time. We believe Search should see virtually no impact from GDPR, but YouTube and Network (especially programmatic) could see some negative effect.”

Alphabet said little on the matter in the earnings release, and not much more during the earnings conference call.

In other words, there’s still no certainty as to what the next era of web privacy will look like and how it might work against Google. That, perhaps more than anything else, makes GOOGL tougher to hold than it has been over the past few years. For all of its “Other Bets,” advertising remains Alphabet’s bread and butter, and the power of its platforms as an advertising medium largely relies on knowing everything it can possibly know about the individuals using its services.

Looking Ahead

Alphabet still is a growth machine, despite all the ways the web is changing, despite how much advertising is becoming a commodity, and despite how consistently per-click revenue continues to fall. However, with each day’s gradual transformation of how people see and use the world wide web though, Google’s dominance – at least in the western hemisphere – weakens.

It hasn’t mattered yet. The mass migration to, and adoption of, mobile internet has proven plenty fruitful for Alphabet.

But with total impressions flat year-over-year and up only slightly from Q4’s total, one can’t help wonder how close we are to “peak mobile web,” akin to “peak auto” we saw in the automobile industry just a couple of years ago. Alphabet knows it’s going to have to develop new revenue-bearing products and bring them to the market for the point at which the total addressable market of would-be web users peaks and those users stop adding to their daily consumption of digital material.

Throw in the prospect of tighter regulatory control, and Alphabet’s results in the foreseeable future could be further crimped.

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