As a shareholder I am quite pleased with the Alphabet (GOOG, GOOGL) Q2 2016 earnings call as a writer less so. Porat and Pichai covered many different subjects and the call was lacking a clear "theme". First a few surprises: not a word about Pokemon Go. The Niantic game drives quite a bit of in-app purchases of which Google receives 30% on Android phones. In addition Alphabet owns a % stake in Niantic. As the game required virtually zero additional investment by Google, its all FCF dropping straight to the bottom line after tax, it should have some impact. Google is a huge company but it trades at a high multiple so it doesn't require all that much additional FCF in an absolute sense to start moving the needle. That's why it surprised me there was not a pip about it.
The second thing that surprised me was the limited commentary on Cloud. Earlier this year Cloud was very much in focus and it was very much a theme on the previous earnings call. I wrote an article about it that I foolishly called "Google: The Pie In The Sky," which ensured no one would read it. There was some commentary but it certainly wasn't front and center.
To get on with the key takeaways. As the call was characterized by a broad ranging presentation and discussion of all the moving parts within Google they were all discussed somewhat superficially. I highly recommend reading the transcript yourself but wanted to highlight the bits and pieces that are 1) Important 2) Novel; surprising or not really part of what we know about Alphabet already 3) Help to understand the company holistically.
The numbers are great
Alphabet published some great numbers and it looks like it will surge today. CapEx came in at $2.1 billion only and the substantial majority served to support Google. That shows the "Other bets" aren't quite the money pits they are made out to be. Another important number is Operating Cash flow which came in at $9.1 billion. After the aforementioned CapEx you can use it to get to FCF of $7 billion. The Operating Cash Flow plays an important role in my investment thesis for Google as I believe most of the CapEx is growth CapEx. It's probably well spent but I reckon Google could go for a long time without much in the way of CapEx and still generate $9 billion and more per quarter. If you think about annualized Operating Cash Flow that way and subtract some of the $78 billion of cash and marketable securities (61% held overseas) from the Enterprise Value you can quickly get to a very modest multiple. Far from a scientific valuation thinking along these lines will give you an idea how modest the market priced this company with its robust cash flow.
Machine learning becoming increasingly important
Pichai did go on a bit about machine learning which is all the buzz right now. Still, it was interesting to learn that over 100 teams at Google are employing machine learning including Street View, Gmail and Voice Search. The RankBrain signal, one of the hundreds of signals Google's search algo relies on, isn't something new but it is apparently already implemented in 40 languages and fairly accurate predicting which search results users will favor. RankBrain makes it very easy to demonstrate Google's competitive advantage. Obviously machine learning requires an ongoing relationship with a user to be effective. The more data (for example your queries and your response to delivered queries) the better RankBrain will understand you. Suddenly, the search engine with a dominant market share outside of China has an obvious advantage. With much more data to feed the AI its results will be much better for you, even if a competitor had a technically superior technology it could still produce worse results because of the data gap. A dynamic I've argued to exist before but is getting more pronounced because of the machine learning. To end with an interesting example by Pichai:
Machine learning is also creating an impact in other ways. Just last week, we announced a test that applied DeepMind's machine learning to our own Google data centers, resulting in up to a 40% reduction in the energy we use for cooling. This will greatly improve efficiency. And when we publish our research, we hope it will enable others to reduce emissions, too.
A 40% reduction in cooling energy used is nothing to sneeze at and ties in very well with my next takeaway.
The third quarter could be a tough one
CFO Porat is starting to sound more Googley and less Morgan Stanley (NYSE:MS) every earnings call but importantly still brings all the visionary talk back to some down to earth number crunching. I particularly liked the comment about expenses:
I've commented many times that our focus on long-term revenue growth does not give us a pass on managing expenses. We invest a lot of time and effort in assessing how to manage for revenue growth with the utmost respect for the resources deployed and a focus on getting the best return on those resources, recognizing that in some areas secular trends are creating margin headwinds.
It's reassuring to hear Alphabet is seriously looking to save money as well make it. The company isn't just saving power through AI but also looking at server utilization and other things. On the CapEx side most of the money goes to the Google segment and to the Google fiber segment. The moonshot projects that get a lot of press aren't sucking up that much of the sizeable CapEx budget.
Alphabet looks like a great steward of our capital Porat did give off a couple of subtle warnings about the next quarter without providing exact guidance:
- The annual equity refresh for employees is coming up. This will be another sequential increase in stock based compensation going towards employees.
- The head count tends to pick up in Q3 because that's the quarter the company takes new graduates on board.
- Marketing costs are heavily weighted to the second half of the year due to the holidays but in my humble opinion this should be more than outweighed by revenues also being weighted towards the holiday season.
- The board may look at it, but buybacks are done for now.
I continue to be pleased with the growth and performance of Alphabet and expect more to come. It remains among my top 3 positions.
Disclosure: I am/we are long GOOG.
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.