Alphabet's Costs Up: Not Unusual for a Growth Stock

Because Alphabet GOOGL is so big, we sometimes forget that it’s also growing so fast. There are very few companies of this scale that continue to beat the law of large numbers quarter upon quarter.

So yes, I don’t think that the 23% increase in revenue, 28% increase in earnings or 22% increase in cash flow are anything to feel miserable about. It’s just that the company continues to do this so effortlessly that we tend to forget that the most important test of performance is the bottom line.

Costs Escalating for a Reason

Most people are concerned about the higher TAC affecting the Google unit because sharing a larger percentage of revenue with phone OEMs, carriers and publisher partners obviously means lower profitability. Management attributed this to higher programmatic and mobile search as a percentage of sales. Another factor could be a renegotiated contract with Apple AAPL.

The point to note here is that despite this pressure on margins, both earnings and cash flow increased. This means that the company is seeing such high volumes that the negative impact on margins is totally offset. Seen another way, Google is incurring some cost to generate growth, which it is realizing today.

Other cost of revenue also increased last quarter due to the reallocation of some G&A expenses, higher content acquisition cost for YouTube and higher hardware cost. It would have been good if management had added color on how much each factor contributed to the increase, but that detail is missing.

It does look like increased content acquisition cost was the most important reason (note that other costs have been increasing steadily over the past year, so it isn’t a one-time thing). Moreover, G&A is typically a much smaller cost head, so the impact of the reallocation was likely small. Also, the hardware cost increase may have been at least partly due to the inclusion of Nest where management expects synergies. So the increased cost was in the interest of better revenue growth prospects.

The R&D increase was attributable to a higher headcount while the marketing cost increase was attributable to cloud, hardware and Assistant. Here again, the higher cost is focused on driving growth in its non-advertising business.

Next up is capex. Considering the fact that half of this was spent on facilities (Google buys rather than rents), the other half, comprising investment in technical infrastructure was not remarkable, and in line with historical trends.

There are of course a number of pieces to this, the first of which is data centers (Google has over 20 sites across 4 continents that are under different stages of construction) to support the continued growth in cloud, search and YouTube.

The second is the increased cost of new technology including CPUs, memory and networking gear.

But the most important, according to management, that accounted for most of the increase was infrastructure to facilitate machine learning. Being the kind of business that it is, machine learning drives opportunities and strengths across all its businesses, including search, cloud, Assistant and in the Other Bets (Waymo) segment. So it makes perfect sense to continue investing, especially when the balance sheet is simply loaded with cash.

Conclusion

It’s natural for growth stocks like Alphabet to be more focused on the future than driving near term gains. So there will be phases during which the company will be building out its infrastructure that will be followed by periods during which it will benefit from the increased operating leverage.

There was a time when the company was perhaps lacking fiscal discipline, but that’s when it was restructured to more realistically match investments with commercial prospects. And Ruth Porat was brought in to oversee things.

Today, that is not Alphabet’s problem. So there’s no reason to panic when the company just reported a good quarter with both revenue and earnings handily beating our estimates.

Recommendations

Alphabet shares have a Zacks Rank #3 (Hold). Internet stocks worth buying instead include #1 (Strong Buy)-ranked Match Group MTCH, or #2 (Buy)-ranked Cyber Agent CYGIY, Etsy ETSY and HealthStream HSTM. Or, take a look at the complete list of today’s Zacks #1 Rank stocks here

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