Alphabet's (GOOGL) latest earnings report suggests the trends that have led it to post 20%-plus sales growth in recent quarters remain quite strong. But it also suggests that recent margin pressures aren't going away anytime soon.After the bell on Monday, the Google parent reported Q1 revenue (excluding traffic acquisition costs, or TAC) of $24.86 billion (up 24% annually), above a $24.26 billion consensus. And after backing out one-time accounting events that boosted GAAP EPS by $3.40, EPS came in at $9.93, above a $9.28 consensus.
But after initially spiking higher on the news, shares quickly gave back their gains and finished after-hours trading down fractionally. Concerns about TAC and heavy spending (more on this shortly) appear to be weighing once more -- three months ago, they led shares to sell off following a mixed Q4 report.
Though not without blemishes, Google's report is (in the views of this observer) fairly encouraging overall, given that shares went into earnings trading at reasonable multiples for a company with Google's growth rates and competitive positioning in several highly valuable markets. Here are key takeaways from the Q1 report and subsequent earnings call:
- Google emphatically put to rest any concerns that its mobile search and YouTube ad momentum was about to meaningfully slow. Paid ad clicks on Google's own sites and apps (they include video ad views that technically aren't "clicks") rose 59% annually, outpacing Q4's 48% growth. This more than offset a 19% drop in cost per click (slightly worse than Q4's 16% drop), the result of mobile search and YouTube ad prices being lower on average than PC search ad prices.
- CFO Ruth Porat noted mobile search was once more the largest driver behind Google's ad growth, and both Porat and CEO Sundar Pichai sounded upbeat about search ad trends. Though there have been worries about Amazon.com's (AMZN) impact on Google Search, both due to the growth of Amazon's ad business and the tendency of Amazon shoppers to go straight to its site/apps, Google Search remains a one-of-a-kind online marketing vehicle -- including for many businesses that are either competing against Amazon or operate in an industry that Amazon isn't involved in. And like Amazon, Facebook (FB) and others, Google is benefiting from the steady shift of advertising dollars towards online channels.
- TAC -- the ad revenue-sharing payments Google makes to the likes of phone OEMs, carriers and publishers -- remains a real headwind. For the second quarter in a row, it equaled 24% of Google's ad revenue versus 22% a year earlier. Moreover, Porat forecast TAC's share of ad revenue on Google's own sites and apps (13% in Q1) will continue rising, albeit at a slower pace starting in Q2. A revamped search ad revenue-sharing deal with Apple (AAPL) is believed to be contributing to TAC growth in recent quarters.
- Elevated hardware/service costs also raised eyebrows. Alphabet's "other cost of revenue," which excludes TAC, rose 39% annually to $7.2 billion. That's higher than Q4's 34% growth, even though Q4 is a seasonally big one for hardware sales. Porat blamed rising depreciation expenses (the result of heavy capex), YouTube content spend and rising hardware-related expenses.
- Capex soared in Q1: Google's "purchases of property and equipment" jumped to $7.3 billion from a year-ago level of $2.5 billion. Porat noted this figure includes the $2.4 billion purchase of Google's Chelsea Market Manhattan facility, and that overall about half of Q1 capex was related to spending on facilities rather than "compute capacity." But with a portion of year-ago capex also involving facilities, this suggests compute investments still rose sharply. While chip suppliers such as Intel (INTC) , Nvidia (NVDA) and Broadcom (AVGO) can't complain, all this spending will lift Google's depreciation expenses in future reports.
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- Earnings benefited from the fact that Google had just an 11% Q1 tax rate, down from 20% a year earlier. Tax reform played a role, and the aforementioned accounting changes had a 5-percentage-point impact. EPS also got a small boost from $2.17 billion worth of stock buybacks; that's up from $1.13 billion a year ago.
- The Google Other reporting segment, which covers non-advertising businesses such as hardware sales, Google Play transactions, the G Suite (formerly Google Apps) and the Google Cloud Platform (GCP), had another strong quarter: Revenue rose 36% to $4.35 billion. On the call, Pichai noted the G Suite saw accelerating revenue growth in Q1, and that GCP is seeing stronger large-deal activity.
- The Q1 report was the first one for which the Nest smart home hardware unit was placed within the Google Other segment, rather than the "Other Bets" segment. Google also restated its 2017 results to reflect the change. Based on the restatement, Nest had 2017 revenue of $725 million, but also posted a $621 million operating loss. On the bright side, Pichai said that Nest, which was just merged with Google's core hardware team, sold more devices in 2017 than in the prior two years combined.
- Two slower-growing parts of Google's ad empire -- PC search and ad sales on non-Google properties -- did well in Q1. Porat mentioned Google saw "solid growth" in desktop (PC) search in Q1, and Pichai suggested the large investments Google is making to enhance its mobile search experience "translates to desktop search as well." Ad sales on "Google Network Members" properties grew 16% to $4.64 billion ($1.25 billion excluding TAC); ad impressions were flat, but Google's average cost per impression rose 18%.
- Pichai didn't sound worried about the pending arrival of new EU online privacy regulations (GDPR), which among other things require companies to get users to explicitly opt in to any collection of their data for ad-targeting purposes. He mentioned Google was been working for over 18 months on GDPR compliance, and suggested that -- since it relies heavily on the keywords a user inputs -- its search ad business won't be significantly affected by it.
TheStreet's Eric Jhonsa previously covered Alphabet's Q1 report and call through a live blog.