• After Q1 2018, we argued that earnings power was accelerating at Google, and called it a no-brainer buy at $1,000/share.
• We dissect Q2 results, going beyond reported financials.
• We share our main takes from the earnings conference call.
• We update on the investment thesis and recommendation.

Alphabet (GOOG) (GOOGL) is part of the one-of-a-kind IW Portfolio since the Q1 2018 earnings report.

In our initial piece on Alphabet, with the Street worrying about decreasing margins and outsized capital expenditures, we looked beyond reported financials and concluded:

Contrary to the prevailing market sentiment, we believe that Alphabet's economic earnings growth is actually accelerating [...]

At $1000/share, we estimate that Alphabet is trading at about 1.25x Earnings Power Value (ex-cash and without "Other Bets"), that is, at a 25% premium of the net present value of the cash flows to shareholders, had management decided to stop investments in growth and distribute all FCF [...]

Hence we see the $1000/share price as very compelling. So compelling that it raises the question of how the market is missing it. 

Two weeks later, we went even further and advanced Alphabet's forward earnings power yield (5.5% at the time) as the opportunity cost of tech investments.

Today, following a Q2 report in line with our expectations, the stock is up some 25%. And quite frankly, nothing has really changed. So much for market efficiency.

In this piece, we comment on the main takeaways from the earnings report and conference call and update on the investment thesis.

Sundar Pichai, CEO of Google (source: wccftech)

The numbers

Revenue

In Q2 2018, Alphabet delivered another strong top-line quarter, with FX-neutral revenue up 23% YoY, just as in Q1.

By segments and before FX adjustment, Google advertising revenue was up 24%, led by mobile Search and YouTube; Google other revenue, up 37%, driven by Cloud, HW and Play; and Other Bets were up 40%.

Operating income

Reported operating income grew 14.7% YoY to $7,878 million, with 230 bps of operating margin compression to 24.1%, due to a 260 bps gross margin hit, partially offset by operating leverage.

These and the following numbers are before accounting for the European Omission Commission fine of €4.34 billion (about $5.1 billion) related to certain contractual provisions in agreements between Google and Android partners. We deal with the impact of the fine later.

Gross margin

Increases in traffic acquisition costs as a percentage of revenue (TAC rate) were responsible for only 40 bps of that margin contraction. Although the ongoing mix shift towards mobile search and programmatic, which carry higher TAC, will continue pressing margins, the TAC rate growth deceleration should reassure investors. CFO Ruth Porat described the Q1 TAC rate hit as non-recurring (presumably, due to changes in the partnership agreement with Apple), and Q2 financials confirm that view.

Ad monetization remains strong. In Google properties (Search, YouTube, Maps, etc.), paid-click YoY growth (58%) handily offset cost-per-click declines (-22%). In Google Networks Members' properties (3rd parties using AdMob and AdSense), cost per impression increased 14% YoY in the face of flattish impressions (1%), due the ongoing shift to programmatic.

For investors not familiar with Google's language, "cost-per-click" is not a cost to Alphabet, but represent the average amount Google charges advertisers for each engagement by users.

The lion share of the gross margin hit was due to "Other costs of revenue", up 41.5% YoY and 4.2% sequentially. The incorporation of the HTC team and aggressive investments in HW and computing platforms are to blame for that.

Adjusted financials

The implementation of the new accounting standard ASU 2016-01, that changes the accounting rules for equity security investments, increased reported operating expenses by $328 million. Adjusting for this non-cash charge brings operating income to $8,206 million, for 19.5% YoY growth and 25.1% operating margins.

Among the opex items, S&M increased the fastest, up 30.5% YoY, as Google keeps hiring aggressively to build its enterprise-grade Cloud sales force. We believe that part of S&M expenditures are better seen as investments to attract and retain customers than as incurred expenses. Had S&M expenditures grown in line with revenues this quarter, operating income would have increased 21.6% YoY to $8,350 million, and operating margin would have come in at 25.6%.

We believe that these figures reflect earnings power better than the raw reported financials.

The European Commission fine

In estimating Google's earnings power yield of 5.5% in Q1, we wrote:

We expect the company to remain on the target of anti-trust agencies and tax authorities in the US, Europe and elsewhere, but we will account for the economic impact of increased regulatory pressure through a higher tax rate, rather than through recurring fines. [...]

we use a 21% [tax] rate to leave some 500 basis points of margin to account for future anti-trust fines, burdensome regulations and targeted tax initiatives.

The $5.1 billion fine represents about 14% of annual forward operating income. Hence, the "regulatory" margin of safety we used in our estimation of earnings power yield will prove sufficient provided that Google is not the subject of similar penalties more often than once every three years ("penalties" includes fines as well as profit declines due to business restrictions). Despite the to-be-appealed record EC fine, we continue seeing the 5% margin of safety as sufficient.

The conference call

There was no big reveal during the conference call and Q&A sessions. The conversation turned around the increasing importance of artificial intelligence (AI) for the company's products, enhancements in tools for advertisers, strength at Cloud and progress in emerging economies.

In contrast, little new was shared on Waymo and the healthcare initiatives.

Artificial intelligence

To say that AI is important for Alphabet's future would be an understatement. AI is at the core of virtually all big Google initiatives: from Search and advertising, through YouTube recommendations, Maps content upgrades and Cloud services, all the way to Home, the Assistant, Waymo and Verily.

In fact, we view Alphabet as "the AI company".

AI provides extraordinary R&D and capex leverage to Alphabet, putting competitors with lesser AI use cases at a cost disadvantage --that is true to virtually all competitors.

Even more importantly, buying into the AI leader provides shareholders with an optionality for future AI applications that we are not even fathoming today.

Advertising

The 58% paid-click YoY growth speaks volume on the health of the advertising business.

Alphabet operates some of the most valuable assets in the advertising industry (Search, YouTube, Maps, Android/Play). It is rightly giving priority to user experience over monetization, but being in the middle of strong secular trend, 20%+ top-line growth is almost inevitable.

In Q2, company initiatives were more centered on empowering advertisers through better tools and data rather than new ad formats.

Cloud

S&M expenses (+30.5% YoY) and capital expenditures ($5.5 billion in Q2) are going through the roof. Both are being dominated by investments in Cloud.

But the company has something to show for it.

Google other revenue, which includes Cloud, was up 37% YoY. The company boasted a series of key wins and collaboration extensions with the likes of  Domino’s Pizza (DPZ), SoundCloud, PricewaterhouseCoopers, Carrefour (CRERF), Target (TGT), AirAsia, Banco Itaú in Brazil and several financial institutions.

Sundar reiterated that the service is ready for big wins from a product and technology standpoint, with the go-to-market as the bottleneck. Hence the 30.5% YoY S&M expense growth.

The differentiation is being driven by strength in security, deep learning frameworks, and the G Suite, that keeps bridging the gap with Microsoft Office (MFST).

Emerging economies

A last bit from the conference call was the progress in adoption of Google products in emerging economies such as Indonesia, India, Brazil, and Nigeria.

The company has put a great deal of effort into adapting its offerings to the idiosyncrasies of those countries and is starting to reap rewards, with Google Maps mentioned as example, with use up 50% YoY.

Takeaways and future work

At $1,250, the stock is no longer a steal.

But it remains a solid buy, cheaper and with better and longer growth runways than most other US tech companies.

It is an excellent example of a low-risk, high-reward play. The downside is limited by the profitability and competitive advantages of the current advertising business. The upside, given by the various growth initiatives, of which YouTube and Cloud are the most defined, with exciting call options in Waymo and life sciences.

What was an (adjusted) 5.5% forward earnings yield at $1,000/share is a 4.4% yield at  $1,250/share. Look for better yields among your current tech holdings with comparable growth prospects (mid to high teens at 20%+ ROIC) and you are unlikely to find a better deal.

We recommend investors to maintain or add to their long positions.