Analysis: GOOGL AMZN MSFT

Alphabet (GOOGL) reported its fourth-quarter results after the bell on Monday, beating on both the top and bottom lines. Revenues of $39.276 billion (up 23% in constant currency year over year) topped the consensus of $38.904 billion, and earnings per share of $12.77 (up 32% year over year) beat the consensus of $10.86. Additionally, Ex-TAC revenue of $31.84 billion beat the $31.3 billion consensus. Meanwhile, operating margins declined by 3 percentage points year over year to 21% as operating income of $8.203 billion was short of expectations of $8.607 due to higher than expected expenses (more on this below).

Digging deeper into the report, revenue in Google Properties (formerly labeled "website" -- in other words, the core business) increased 21.5% year over year to about $27 billion for a solid beat on the $26.75 billion consensus. Google Properties' strong top-line results were driven by mobile search, YouTube, and then desktop search.

Regarding YouTube, the platform as a whole now welcomes nearly 2 billion monthly login users. Engagement from the community remains strong, with the number of YouTube channels with more than 1 million subscribers almost doubling in the last year. The Music and Premium services business are now available in nearly 30 countries, an increase from 5 at the start of 2018. Although we did not get a specific breakout of numbers, CFO Ruth Porat said that, brand advertising has "grown at a strong pace."

Google Network Member properties revenue came in at $5.613 billion (up 12.5% year over year), in-line with the $5.557 billion expectation. The continued increase in sales reflects momentum of Admob and Google Ad manager.

Google Other revenue, which includes Pixel sales, cloud services, Nest (which was previously in Other Bets), and Google Play, was $6.487 billion (up 30.6% year over year) in the quarter, edging estimates of $6.427 billion. The growth in the quarter was driven by Cloud, hardware, and Play sales.

Regarding the cloud, as usual, management was not transparent as we would prefer in breaking down specific revenue totals. However, there were several key nuggets of information that we believe are worthwhile to point out. First, CEO Sundar Pichai said, "Google Cloud is a fast-growing, multi-billion-dollar business that supports major global 5000 companies in every important vertical with a robust enterprise organization." Later he added that in the previous year, "we more than doubled both the number of Google Cloud Platform deals over 1 million as well as the number of multiyear contracts signed." Pichai noted that he is "excited at the traction we are seeing," and in the company's ability to win large customers. Although the Google Cloud is not as significant of a player as Amazon (AMZN) Web Services or Microsoft (MSFT) Azure, we believe cloud-computing is not a zero-sum industry and that there is plenty of room for growth from several key players.

In the Other Bets segment, which covers businesses such as Waymo, Google Fiber, and Verily, reported an operating loss of $1.328 billion on $154 million of revenue. Both of these compare negatively to the consensus which expected an operating loss of $787 million on $213 million revenue. For the full year 2018, Other Bets revenue were $595 million, up 25% from a year ago, primarily generated by Fiber and Verily. Meanwhile, operating loss for Other Bets was $3.4 billion, more negative from $2.7 billion in 2017. Impacting operating income (or losses) in the quarter was an increase in accrued compensation expenses that reflects increases in valuation of equity. We think that might have been tied to Verily, which recently received a $1 billion investment round by Silver Lake, and that was on top of a previous $800 million of funding raised by Temasek. At Waymo, the company's industry-leading autonomous driving technology business, management highlighted the December launch of Waymo 1, the company's ride-hailing service. We continue to expect an increase valuation of Waymo as monetization efforts become more apparent. Although the operating losses for the full year of 2018 were steep, we are willing to tolerate such losses due to the growth potential within each business. Meaningless to current earnings, these are the "call options" that we speak of because we do not think their potential valuations are sufficiently priced into GOOGL.

Looking at TAC, or essentially what Alphabet pays partners to support its advertisements, total TAC came in $7.436 billion (+115% YoY), which was better than the $7.624 expectation. Despite the annual increase, total TAC as a percentage of Google advertising revenues was down 1 percentage point year over year to 23%. This reflected a favorable revenue mix shift from network to sites. Looking ahead, CFO Ruth Porat reiterated what she has continually said on these conference calls in that, "while the pace of year-on-year growth in sites TAC as a percentage of sites revenues slowed after the first quarter of 2018, we do expect the sites TAC rate to continue to increase year-on-year, reflecting ongoing strength in mobile search."

As for the monetization metrics, paid clicks on Google Properties, which is a measure of the number of ads sold (think inventory supply), increased 66% YoY. Meanwhile, Cost per click on Google Properties, which is essentially ad prices, declined 29% year over year. These results compare favorably to the third quarter, which had a 62% increase in paid clicks and a 28% decline in cost per click. We think the decline in cost per click is unsupportive of a true bear thesis against the stock because when you think about it, Alphabet accelerated the number of paid clicks on Google Properties and managed only a minuscule additional decline in price. In other worlds, volumes greatly increased with only a minimal impact on price.

Impressions on Google Network Members' properties increased 7% YoY, which is the same pace on a sequential basis. Lastly, Cost-per-impression on Google Network Members' properties, defined as the average amount Alphabet charges advertisers for each impression displayed to users, advanced 5% YoY and 7% sequentially.

Back to what weighed on operating income, cost of revenues (including TAC) increased 25.5% year over year to $17.918 billion. When excluding TAC, Other cost of revenues was $10.5 billion, which represents an increase of 34% year over year. The key drivers behind the growth in costs were 1) content acquisitions costs, primarily for YouTube's ad-supported content and its new subscription businesses: YouTube Premium and YouTube TV; 2) costs associated with the data center and other operations, including depreciation; 3) hardware related costs for Made by Google and Nest family of products. The biggest increase to operating expenses, which increased 27% year over year to $13.2 billion, was R&D. The main driver of higher costs here was additional headcount, which seems to support the growing cloud franchise. On the CapEx side, management expects the rate of year-on-year growth to "slow meaningfully", and in terms of mix they expect an uptick in data center investments relative to services.

Looking at cash flows, net cash provided by operating activities of $12.987 billion exceeded expectations of $11.757 billion, while free cash flow of $5.906 billion was light of the $6.0 billion expectation. The company ended the 2018 year with $16.701 billion of cash and cash equivalents on the balance sheet, up from $10.715 billion from a year ago. Much of that cash will be put to good work, as on the conference call management announced that the Board has authorized a new share purchase program worth $12.5 billion.

Overall, this was a very good quarter with solid beats across most key metrics. However, shares are retreating in the after-hour markets to about $1,110 per share, roughly the price the stock began the day at. Yes, expenses were on the rise and that will put some fear in what it means to operating income growth, just like it did with Amazon, however, its impacts are manageable because the company's earnings power is still quite strong. Even with a company of Alphabet's size and expense total, operating income still grew by 7% year over year. And if there was ever to be a company that needed to increase its operating expenses in order to keep up with the rapid growth of the business, there are few in the world that are as well-equipped to handle such task as Alphabet.