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Alphabet (GOOGL) Missed, Shares Tanked, But It's Business As Usual

Alphabet’s GOOGL first-quarter earnings missed the Zacks Consensus Estimate on revenue that was roughly in line.

Neither Google nor Other Bets stories changed materially. On the Other Bets side, revenue remains lumpy because of the early stages of most businesses included in it. Nest appears to be the one piece growing nicely. Investments remain focused mainly on Fiber efforts (management spent $280 million on capex last quarter, mainly on Fiber).

The main drivers of the Google business also haven’t changed. Pricing remains under pressure, both on account of the ongoing FX concerns as well as continued strength in TrueView. Volumes are very encouraging however: total paid click growth of 29% was one of the strongest in recent quarters.

Google continues to report strength on the mobile platform, which is very encouraging given that mobile devices generally use apps instead of browsers. The company has greater control on the browser through Android as well as through distribution agreements with Apple AAPL. But upcoming threats shouldn’t be ignored either: Apple may not renew its agreement, Microsoft MSFT Windows 10 could steal overall search market share, Facebook FB graph search and the social network itself could take away advertising dollars, and Amazon AMZN already takes care of most product searches.

In January, management demonstrated the effectiveness of “moments” or its unique ability to connect buyers to customers at times when they have high purchase intent. And it is now highlighting a new concept called Customer Match that helps brands connect with important customers across Google Search, YouTube and Gmail. Last quarter, it also launched Model Automotive Ads, which management said led to a 50% revenue increase compared to previous campaigns.

Emerging areas including cloud and Google Play continue to do well although management doesn’t provide too much color. It does provide juicy tidbits however such as same sales on Play, which increased 50% over last year. The company started branding YouTube Red as its premium service on which it launched YouTube Originals in the last quarter.

Cash and Investments continue to pile up with 60% ($45 million) residing overseas. Management clearly wants to keep investing because there is so much room for growth in Other Bets.

The numbers in detail-

Revenue

Gross total revenue of $20.26 billion dropped 5.0% sequentially and grew 17.4% year over year (up 23% in constant currency or CC).

Alphabet’s hedging programs partially offset the negative impact of the stronger dollar in the sequential comparison but weren’t that effective in the year-over-year comparison. Consequently, the stronger dollar had a $762 million negative impact on the year-over-year comparison (total revenue was up 23% on a constant currency basis). Hedging programs offset $169 million of the FX impact.

The geographic distribution was as follows: the U.S. generated around 46% of revenue, down 8.9% sequentially and up 20.8% from a year ago. The U.K., with a 9% revenue share was flat sequentially and up 11.3% (21% ex-FX) from last year. Other international markets accounted for the balance, representing a sequential decline of 1.7% and a year-over-year increase of 15.3% (25% ex-FX).

Google Segment

The segment includes search, advertising, Play, hardware and Cloud & Apps. So first, the search business-

Revenue from Google-owned sites dropped 4.1% sequentially, while that from partner sites dropped 10.9% resulting in a total advertising revenue decline of 5.5%. Both segments grew (20.1% and 3.2%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 71% and 18% of quarterly revenue, respectively.

Management said that mobile search continued to benefit from improvements in ad formats and delivery initiated in the third quarter of 2015 and remained optimistic about search revenue growth on both tablets and desktops. TrueView and Google Preferred were the primary drivers of YouTube revenue although app promotions are growing into a bigger contributor.

The traditional AdSense benefited from strength in programmatic as offset by a decline in the traditional network business.

Other revenue was down 1.4% sequentially and 18.3% year over year to around 10% of revenue. The strength was on account of Play Store sales (apps, content and chromecast). Google for Work and cloud revenue and hardware also contributed.

Other Bets Segment

Alphabet broke out the segment for the first time last quarter, which includes its Fiber, Verily, Calico, Nest, self-driving cars and incubation activities in X Labs. Revenue was up 9.9% sequentially and 107.5% year over year.

Since this segment is a combination of several businesses that are in the pre-revenue stage, operating different models and serving diverse end markets, the results are likely to be lumpy in any given quarter.

Total traffic acquisition cost, or TAC (the portion of revenue shared with Google’s partners and amounts paid to distribution partners and others who direct traffic to the Google website) was down 6.6% sequentially and up 13.2% year over year staying at 21% of total advertising revenue. The percentage was down slightly from both the previous the year-ago quarters indicating more efficient revenue generation.

TAC paid out to network partners was down 10.2% sequentially and up 5.7% year over year, representing 70% of network revenue.

TAC for distribution arrangements was up 2.2% sequentially and 33.3% year over year, representing nearly 9% of Google website revenue.

Net advertising revenue, excluding TAC was down 5.3% sequentially and up 17.0% year over year.

Revenue net of TAC came in at $16.47 billion, down 4.7% sequentially and up 18.4% year over year, roughly in line with the Zacks Consensus Estimate.

Margins

The gross margin of 62.2% expanded 63 bps sequentially while shrinking 93 bps from last year.

Price declines were a big negative in the year-over-year comparison but were less of a negative in the sequential comparison.

The cost per click (CPC) was down a respective 0% and 9% from the previous and year-ago quarters. On a sequential basis, they were up 2% on Google sites and down 12% on network sites. CPCs on Google sites were down 12% from last year, while network CPC declined 8%. FX remained a dampener for the CPC in the last quarter as also the growing mix of TrueView ads on YouTube, where prices are lower.

Paid clicks grew-3% sequentially and 29% year over year, helped in part by growing volumes of mobile and TrueView ads on YouTube. It was the second straight quarter that both Google site and Network paid clicks grew (38% and 2%, respectively) from the year-ago quarter.

Operating expenses of $7.27 billion were down 6.4% sequentially and up 12.6% from the March quarter of 2015. The operating margin was 26.4%, up 115 bps sequentially and 60 bps from last year. As a percentage of sales, R&D increased 16 bps sequentially and 67 bps from last year. G&A increased 10 bps sequentially and dropped 202 bps from last past year. S&M on the other hand dropped 78 bps sequentially and18 bps from last year.

Non-operating losses were $213 million compared to $180 million in the previous quarter and gains of $157 million in the March 2015 quarter.

Alphabet reported net income of $4.21 billion, or 20.8% of sales, compared to $4.92 billion, or 23.1% of sales in the December 2015 quarter and $3.52 billion, or 20.4% of sales in the year-ago quarter. GAAP earnings of $6.02 a share were down from $7.06 in the previous quarter and up from $5.10 in the year-ago quarter.

Balance Sheet

Alphabet has a solid balance sheet, with cash and short term investments of around $75.26 billion, up $2.20 billion during the quarter. Management said that $43 billion of this is held overseas. The company generated around $7.66 billion of cash from operations in the last quarter and spent $2.43 billion on capex, netting a free cash flow of $5.23 billion. Alphabet also spent $2.10 billion to repurchase shares, $34 million on acquisitions and refinanced some debt. Net cash at quarter end was around $70 billion.

Recommendation

Alphabet shares have a Zacks Rank #3 (Hold).

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