Unlike most large-cap public companies, Alphabet (NASDAQ:GOOG,GOOGL), more commonly referred to as Google, doesn’t report adjusted earnings. That’s not necessarily a problem for Google stock — even as it trades at a five-month high. But understanding the actual underlying business is key to understanding GOOGL stock.
Non-GAAP accounting has been the subject of debate for years. Many observers and investors argue that companies use ‘adjusted’ figures to hide data they won’t investors to see — or create growth that isn’t really there. But Google stock shows the flipside of GAAP accounting: it’s not quite as accurate, or indicative of underlying performance, as some think.
Again, that doesn’t mean GOOGL stock is a sell (even though I do question valuation here). But it does mean that what Google’s GAAP earnings show doesn’t quite match what the business is doing.
Earnings and Google Stock
Here’s the trajectory shown by Google’s GAAP earnings per share figures, along with 2019 analyst estimates:
- 2016: EPS of $27.85, rising 14.4% year-over-year;
- 2017: EPS of $18, declining 35% year-over-year;
- 2018: EPS of $43.70, increasing an astonishing 143% against 2017;
- 2019 estimates: $47.05, up 7.7%.
To look at those numbers would suggest a rather volatile business. But, of course, that’s far from the truth. Google — given its dominance in advertising — is actually a quite stable business. Rather, one-time factors have been at play.
In 2017, for instance, the company took a one-time charge of $14.05 per share due to the accounting effects of tax reform. (Most of that came from a one-time tax on its overseas earnings.) Accounting rules changed in 2018, requiring the company to account for changes in the valuation of its equity securities. (Alphabet owns stakes in companies as diverse as Lyft, Care.com (NYSE:CRCM), Snap (NYSE:SNAP), FanDuel, and LendingClub (NYSE:LC).
According to the Q4 2018 release, that accounting change added $5.70 to 2018 EPS. And with a Lyft IPO on the way, the new rules should further benefit Alphabet earnings in 2019.
Removing the two major one-time effects, Alphabet’s growth profile looks much different:
- 2016: EPS of $27.85, rising 14.4% year-over-year;
- 2017: EPS of $32.05, climbing 15% year-over-year;
- 2018: EPS of $38.00, up 18.6% against 2017;
- 2019 estimates: ???
After all, we don’t know how much benefit from the equity ownership analysts are modeling — adding another layer of complexity to Google stock in 2019.
Other Factors That Impact GOOGL Stock
But there are other factors at play here that impact Alphabet earnings. What looks like an acceleration in EPS growth in 2018 — excluding one-time factors — actually wasn’t. Operating income growth was minimal, rising less than 1% after a 10% increase in 2017. Instead, Alphabet — backing out the one-time effect in Q4 2017 — just benefited from a lower tax rate.
From that standpoint, it looks like Alphabet earnings actually are slowing to a crawl. Operating margins are compressing, and underlying profit is barely growing. But here, too, investors have to look closer.
Once again, there are one-time factors. The first is the effect of fines levied by the European Commission. Alphabet breaks out segment-level profits, and ‘reconciling items’ are deducted from its operating profit. Those items include corporate overhead — and of late, those fines. The impact from reconciling items rose from $598 million in 2016 to a whopping $6.84 billion in 2018.
There’s another factor affecting operating earnings. Alphabet is losing more money from its “Other Bets” businesses. Operating loss there was $3.36 billion in 2018 — against $2.73 billion the year before. That’s not a surprise: the category includes startup businesses like self-driving car business Waymo and life sciences incubator Verily.
If an investor just looks at operating profits in the Google segment — which excludes Other Bets and the impact of fines — all seems to be well. Profits rose 20% in 2016, 18% in 2017, and 13% in 2018. Growth is decelerating, admittedly, but still solid.
GOOGL Bulls and Bears
What’s interesting about the different ways of looking at Alphabet earnings is that they can drive very different perceptions of GOOGL stock. That’s true from both short-term and long-term perspectives.
For instance, Google stock actually dipped after Q4 earnings crushed consensus EPS,which seemed strange, but the beat came entirely from the equity investment accounting effect: operating results were actually below estimates.
Long term as well, there’s an obvious divide. The bull case here is that Alphabet has $100 billion-plus in cash and valuable businesses like Waymo and Verily that aren’t yet contributing to results. In that context, a ~25x forward P/E multiple looks reasonable and may not even incorporate those assets.
A skeptic, however, might point to the steadily decelerating growth in the Google segment. Operating margins are coming down even beyond the impact of Other Bets and EU fines. Competition is rising, with Amazon.com (NASDAQ:AMZN) becoming a new and dangerous rival in advertising (which still drives the overwhelming majority of Alphabet revenue). And rising traffic acquisition costs, plus the increasing usage of apps over browsers, portend a risk to the core search business here.
There are logical takes on both sides, particularly with GOOGL stock having recovered its Q4 losses with strong performance YTD. But to make that logical take, an investor needs to truly understand the numbers. As seen here, that takes some digging — and investors will need to continue to dig as Alphabet releases results going forward.
As of this writing, Vince Martin has no positions in any securities mentioned.