Congratulations are in order for Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) investors. According to Citi Research, the company has once again surpassed Facebook Inc (NASDAQ:FB) as the most popular tech company among hedge funds. A total of 16 hedge funds now own GOOGL stock, one more than FB stock. That’s an improvement for Alphabet since the two were tied in Q1 at 13 hedge funds apiece.
The new development is actually quite surprising, seeing how badly GOOGL stock has performed ever since the company reported Q2 numbers that beat on both the top and bottom line. The stock is down 9% since the earnings report, taking its year-to-date return to 17% compared to 45% return by FB stock.
So, what beef do GOOGL investors have with the company? Simply put: rising costs, specifically Google’s rapidly expanding traffic acquisition costs. These are payments the company makes to partners for the privilege of making its search engine the default search tool on their respective platforms. Google’s TAC hit the highest point in eight years during the last quarter after clocking in at $5.09 billion, a 27.9% increase from a year ago. TAC as a percentage of GOOGL revenue came in at 22% compared to 21% in last year’s corresponding quarter.
Rising operating costs are always a cause of concern for long-term investors because that translates to squeezed margins and thinner profits. In the case of GOOGL, though, there is a method to the madness.
Mobile Players Hogging GOOGL TAC
Mobile players such as Apple Inc. (NASDAQ:AAPL) and Samsung have been hogging most of Google’s TAC. Before the founding of Alphabet in late 2015, Google had always kept a tight lid on its operating costs. But a legal lawsuit finally spilled the beans when it revealed that Google paid Apple a cool $1 billion in 2014 to be iOS’ default search engine. That revelation jolted investors because it served as an excellent contemporaneous indicator of just how much the company had become dependent on mobile players to drive the top line.
Now, Bernstein Research has done some extrapolation and come up with findings that Google will fork over $3 billion to Apple for iOS TAC. That effectively means the line item has tripled in just three years. But, that’s not even the half of it. Another report says Samsung Electronics has renewed its license payment contract with Google to pre-install Google Search in Samsung’s smartphones. According to the Korean Herald, the amount Google will pay to Samsung as TAC could hit $3.5 billion in the current year.
So, why is Google forking over so much cash for TAC? You can blame it on the rapid growth of mobile advertising. eMarketer estimates that Google’s global mobile ad revenue will clock in at nearly 60% of total ad revenue during the current year, compared to just 46% two years ago. This will mark the first time that mobile ads will bring in the lion’s share to the company’s topline compared to desktop ads.
Model Shift for GOOGL Stock
That represents a significant shift in Google’s operating model. You see, Google Chrome can only envy the go-go days when Microsoft‘ Corporation’s (NASDAQ:MSFT) Internet Explorer owned a market share north of 90%. Being so dominant means that you can afford to ignore competing browsers and still be none the worse for wear.
Unfortunately Chrome’s browser market share seems to have peaked below 60%, and has little hope of making further inroads. Chrome has to compete with formidable mobile browsers including the likes of Safari, Android Browser, Opera and IE. If Google want’s the other 40% of the search pie, it has little choice than to pay these guys for Google Search to become the underlying search engine on their browsers.
Investors will finally have to come to terms with the fact that Google’s core operating model is rapidly changing, and the days of desktop ads dominating are over. The good–Google’s topline has been growing significantly faster than it did a couple of years ago. All those mobile clicks add up, you know. The bad–margins might get dinged a bit, maybe by 2-3 percentage points.
Revenue ex-TAC might not look too good, not to mention that mobile ads carry lower rates than desktop ads. In fact, Alphabet CFO Ruth Porat said as much during the last earnings call when she conceded that the company was more interested in dollar growth and not the quality of earnings.
GOOGL Stock Still Good for the Long Haul
Long-term investors though have little to worry about. GOOGL stock performed poorly in the past due to worries about high operating costs. Google’s opaque reporting back then did not help matters either.
But things have now changed. The company now lays everything bare in its reports, so the uncertainty is not anywhere nearly as bad this time around. This is the new-look Google, and GOOG stock is bound to rebound sooner than later. In any case, Google TAC is likely to stabilize at some point. As long as TAC grows slower than the top line (which is likely to be the case), everything will be just fine.
