Alphabet: Sunk By Hidden Costs

| About: Alphabet Inc. (GOOG)

Summary

Alphabet reported Q1 results that highly disappointed Wall Street.

The Internet search giant generated amazing revenue growth and operating margins considering the currency headwinds.

The recommendation is to own the stock on any big dips due to some hidden costs that sunk the quarterly results.

After the close Thursday, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) sank as the company widely missed analyst targets on the top and bottom line. Looking at the numbers though, some hidden costs appear to be impacting the numbers without the attention of the market.

The stock was interestingly valued at about 19x 2017 earnings going into the Q1 earnings report considering the growth rates exceed 20%. On a dip, Alphabet will trade close to the lows of the last six months where the stock found previous support making the stock appealing.

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When reviewing the quarterly results, investors should quickly review key figures such as the revenue and EPS growth rates and comparisons to analyst expectations. Another key point are the margins.

Having missed both top line and bottom line estimates, the operating margin initially caught my attention. Somehow, Alphabet grew the operating margin to 34% from only 33% last year despite supposedly missing estimates. These numbers suggest that something else is amiss in the numbers.

The EPS miss is very peculiar considering a company with a $500 billion market cap probably shouldn't miss EPS estimates by a wide $0.47. Why were analysts expecting $7.97, if Alphabet could only earn $7.50 on higher margins.

The revenues were a potential culprit with Alphabet missing analyst estimates by $110 million. With the margin levels and tax impact, the revenue miss is a meager hit to the bottom line. Not to mention, the revenues were hit hard by the 600 basis point currency impact. Not exactly a problem that should hurt the stock or impact operations.

One place to blame for the bigger than expected loss is the Other Bets category. The loss in these long shot investments surged to $802 million from only $633 million last year. The operating loss was only $140 million higher than last year when excluding the stock-based compensation. Surely, analysts factored in larger losses from this sector

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Source: Alphabet Q116 earnings release

The real culprit appears in the "other income" section of the income statement. Again this is where telling what analysts forecast is difficult to derive, but the large $370 million shift from last year to a negative $213 million has a roughly $0.43 impact net of a 20% tax rate.

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Source: Alphabet Q116 earnings release

A lot of companies might exclude some of these charges in the non-GAAP numbers, but Alphabet suggests the only exclusion is SBC expense and the related tax benefits.

Of course, this loss from the other income line only gets Alphabet back to the expected numbers and doesn't include an actual earnings beat. Another potential negative impact to the EPS is that the share count reached 699.3 million. The company spent another $2.3 billion during the quarter on stock buybacks, yet the share count is actually up 9.8 million shares from last Q1. Any analyst expecting a decline in the share count from the 697.0 million level in Q4 would see estimates slightly off target.

The expectations that an adult is in charge of Alphabet now after the current CFO took over last year is clearly not correct. Spending appears unabated with the corporate split and analysts appear no better informed about the expected results.

Regardless of the issues discussed above, the stock is attractively priced on dips with operating income growing at over 20% and the stock trading at a lower multiple. Use any dips and market frustration to buy Alphabet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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