Alphabet: The Elephant In The Room

| About: Alphabet, Inc. (GOOG)
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While revenue growth was impressive, GAAP net income growth was poor.

Bottom-line results benefited tremendously from a low tax rate.

How long can this high valuation stick if margins deteriorate?

On Monday, we received the fourth-quarter results from Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). The headline numbers showed big beats, sending the stock to a valuation higher than that of Apple (NASDAQ:AAPL). While Wall Street rushed to raise its price targets higher and higher, most seemed to ignore some key problems with this report.

Everyone loved the big beat on the bottom line, with the company reporting non-GAAP EPS of $8.67 versus a Street estimate of $8.10. However, the company received a big benefit from a one-time item detailed in the press release as follows:

For Q4 2015, our effective tax rate reflects impact of certain one-time items in the U.S., specifically the resolution of a multi-year audit with an ETR impact of 9%, as well as the full year impact of the R&D tax credit with an ETR impact of 8%.

For Q4, Alphabet had an effective tax rate of 5%. For all those who criticize Apple for its tax situation, Alphabet should receive some flak. For the quarter, the company had GAAP net income growth of just 5%, and that included the tremendous tax benefit. Had the tax rate been equal to the year-ago period, Alphabet would have likely reported at least a $400 million decline in net income.

The bottom-line issue shows how Google could be in trouble if it doesn't keep spending in check. For the full year in 2015, GAAP gross margins rose by 137 basis points, but the company's net profit margin rose by just 38 basis points, and that included the big tax break. Had the tax rate stayed constant, Google's net profit margin would have dropped by roughly 74 basis points year over year. With the tax rate most likely returning to a more normal rate in the coming years, the company's margins will become a big issue.

As I write this article, Alphabet is trading at about 23 times expected non-GAAP EPS for this year. If you shift that valuation to GAAP, you are around 28 times. Apple trades for just 10.5 times earnings, with a number of other large tech giants trading in the teens. Now that the company has started to buy back shares, is a dividend also coming? Investors will surely want some of that $73 billion plus in cash. As investors start to think of the company in less of a growth light, will the above-industry-average valuation stick? That's an interesting question for investors looking to buy the stock at an all-time high.

In the end, Alphabet's quarter was not as impressive as the headline results suggest. A big tax break fueled the bottom line beat, likely hiding a drop in quarterly GAAP net income. Over the next couple of years, Alphabet will need to keep spending in check to avoid a big drop in net profit margins. With the stock at an all-time high currently and trading at a valuation higher than Apple, it will be interesting to see how investors react as growth slows, capital returns likely increase, and the valuation potentially comes down. The true question is, can the company increase earnings at a decent enough clip to keep this stock roaring higher?

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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