At Google, look at the incremental economics

When Alphabet (NASDAQ: GOOGL) reported its 2Q17 result this week, its shares immediately dropped 3 percent in after-hours trading. While company revenues were largely in-line with the market’s expectations, its operating income fell short by more than 20 percent. Said another way, Alphabet’s profit margins came in at levels below the market’s expectations.

There is no debate that GOOGL is a business of the highest quality. The company’s unlevered economic returns on invested capital have consistently been above 30 percent pre-tax. And there is every reason to believe GOOGL will continue to innovate. The company employs some of the smartest engineering minds in the world – and is not afraid of investing for the future: GOOGL spends an average of around US$1.25 billion per month on research and development.

Yet, readers of this blog will know that business-quality, no matter how strong, is an insufficient reason to own a business. For if that business quality is already factored into the stock’s price, then outsized returns cannot be expected.

So the question investors need to continually ask themselves is: “What expectations are being implied by the market at the current level of the stock price?”

We believe that the negative surprise investors received by GOOGL’s 2Q17 result was that the company will effectively “pay” for higher growth, if that higher growth is still value accretive. Indeed, CFO, Ruth Porat, said “We’re focused on revenue and operating income dollar growth and not on operating margins.”

This is reasonable. The only problem is, the market was expecting the profitability of this new growth to be in line with the profitability of historical growth. It’s not.

The key to observing this dynamic in GOOGL’s financial statements is to examine the company’s incremental profit margins, not its average profit margins. Incremental margins measure the change in profit per the change in sales revenue; that is, the profit margin of the growth.

As illustrated by the table, one can clearly see that the incremental operating profit margin of the Google business (excluding “Other Bets”) has averaged 34 percent over the prior six quarters. That was, until 2Q17 during which this incremental margin dropped to just 18 percent. That is, GOOGL’s growth is less profitable than its historical growth.

In part, the reduced profitability of GOOGL’s growth relates to the cost of acquiring internet traffic. Think about Google advertising on non-Google online properties: Google essentially needs to pay the owner of that property a fee for the internet traffic. This is known as a “traffic acquisition cost” or TAC. In 2Q17, TAC represented 22 percent of Google’s advertising revenues. One year prior, this was at 21 percent of Google’s advertising revenues.

GOOGL remains a terrific business. But the incremental economics of its core advertising business are not what they used to be. This much is for sure. Investors need to make sure they are not paying for expected incremental economics which are unreasonably optimistic.

Furthermore, investors need to assess how much they are implicitly paying for GOOGL’s “Other Bets” such as artificial intelligence, Google Cloud and Google Assistant. The success of these bets is impossible to predict. Under these circumstance, the way investors can ensure investment success, is to not overpay for these bets.

Montaka does not own shares in GOOGL. While we love the business and are excited by its new technology on the horizon, we believe the current share price implies too high a cost for the company’s Other Bets. We hope this changes one day. And we will be ready if it does.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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