Alphabet Inc.'s (GOOGL) - Get Alphabet Inc. Class A Report second-quarter earnings may have beat Wall Street's expectations on nearly every metric, but that didn't stop analysts from finding something to be worried about.
Shares of the Google parent company were slumping 2.7% to $971.84 on Tuesday morning, continuing a sell-off that began after-hours on Monday.
After Monday's closing bell, the Google parent company said revenues jumped 21% year-over-year to $26.01 billion and posted earnings of $5.01 per share. Both surpassed Wall Street's projected $25.6 billion in revenues and earnings of $4.44 per share. Profits did slide 27.7% year-over-year, however, as Alphabet absorbed the cost of a one-time $2.74 billion antitrust fine handed down by the European Commission last month.
While acknowledging the outperforming top and bottom line results, however, some analysts focused on Google's rising traffic acquisition costs (TAC), or what it pays partner websites to carry advertisements. During the quarter, TAC increased 28% from the year earlier to $5.09 billion, which was higher than the $4.74 billion analysts had estimated. And while Google generated $22.7 billion in advertising revenue, about 22% of that went to traffic acquisition costs.
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Google's TAC to network members rose to the highest level in eight years, largely as a result of higher TAC rates associated with mobile sites and programmatic buying. Alphabet CFO Ruth Porat noted on the earnings call that more mobile searches are subject to TAC. Other things, such as changes in the kind of inventory Google sells to advertisers, may also have spurred the run-up in TAC.
"It appears that product mixes including the changes in the kinds of inventory that Google sells via its networks (for example brand safe and viewable ad inventory, especially including video) could be causing Google to incur higher costs than was previously the case," said Pivotal Research analyst Brian Wieser.
Porat added on the call that she expects TAC to increase, but said that Google views the trend as an indicator of how healthy its mobile business is.
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Meanwhile, TAC to distribution partners, such as Apple Inc. (AAPL) - Get Apple Inc. Report and other smartphone manufacturers, grew 52% from the year ago period, marking the highest year-over-year growth since 2008, Wieser noted. Several analysts said the higher costs from TAC distribution partners could be tied to Apple revising its search deal with Google, which makes Google the default search engine on Apple's Safari browser.
Analysts were divided on whether the costs will present a risk to Alphabet's growth over time. Credit Suisse analyst Stephen Ju said profits are likely to remain strong despite the rising TAC.
"The key item of focus will be the continued increase in distribution TAC due primarily to mobile search -- with this in mind however, the higher-than-expected revenue despite the lower flow thru does result in stable profit dollars for 2018, and overall our investment thesis for GOOGL shares does not change," Ju wrote in a note to clients on Tuesday.
Pacific Crest analyst Andy Hargreaves said the pullback due to TAC concerns represents a buying opportunity, noting that the higher TAC costs are "also critical drivers" of Alphabet's bottom-line profit growth.
"We recommend investors take advantage of the uncertainty around TAC rates and add positions in Google," Hargreaves said.
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