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Morningstar | GOOGL Updated Forecasts and Estimates from 15 Aug 2018

Alphabet continued its strong 2018 performance with second-quarter top and bottom line (excluding the latest fine from the European Commission, or EC,) coming in higher than our projections and consensus. Revenue growth was driven mainly by Google's advertising and other revenue, including the Google Cloud Platform. With traffic acquisition cost rate growth decelerating, operating margin declined slightly less than our assumption. We adjusted our Alphabet projections higher for our five-year forecast period, resulting in an 8% increase in our fair value estimate to $1,300 per share. The market appears to be welcoming Alphabet's earnings results as the stock is up more than 3% in after-hours. Alphabet shares continue to trade in 3-star territory; however, we would be buyers of this wide-moat and high uncertainty name on any pullback.

Total revenue came in at $32.7 billion, up 26% year over year, driven by growth in ad and other revenue. Google ad revenue of $28.1 billion during the quarter was up 24% year over year as online ad spending, mainly on mobile devices, continues to grow. Advertisers are also purchasing more online video ad inventories, from which Google's YouTube benefits. We estimate that ads sold by YouTube account for 10%-15% of the firm's total ad revenue.

While Google is benefiting from more usage of mobile devices by consumers, the firm is also paying higher traffic acquisition costs, or TACs. We were pleased that overall TAC rates stabilized a bit in the second quarter to 22.9%, up only 40 basis points from last year. While this is not indicative of any possible decline in TAC rates, growth in those rates are likely to decelerate, according to management.

Volume continued to drive ad growth as the number of ads sold on Google properties increased 58% from last year, while cost-per-click of the ads declined 22%. In our view, the increase in ads sold represents Google's success at further monetizing its various properties such as Google Maps. Going forward, we expect benefits of higher Google properties' ad loads sold to be partially offset by lower prices, or cost-per-click.

While ads placed on Google's network properties via Google's AdMob increased only 1% year over year, such limited supply did push cost-per-impression 14% higher, demonstrating strong demand for AdMob and programmatic advertising. We must note that the implementation of GDPR in Europe may have negatively impacted the number of ads sold on network properties. We think those will likely post higher growth rates in the third and fourth quarter as more publishers implement GDPR.

Google's other revenue increased 43% from last year to $4.4 billion driven mainly by the Google Cloud Platform, or GCP, and the firm's consumer hardware offerings. We continue to believe Google can leverage its proven technological expertise, including machine learning, which the firm applied to the creation and maintenance of its private cloud platform, to build and maintain public cloud platforms for various businesses. According to management, some new account wins for GCP include Domino’s Pizza, SoundCloud, and PricewaterhouseCoopers. While Google is not a leader in the cloud market, in our view, the firm is well-positioned to remain the third top player, behind Amazon and Microsoft. On the hardware front, Google is making progress selling its Chromebooks to businesses, as the company said units of Chromebooks sold were up 175% from last year.

As we had expected, second-quarter gross margin declined 400 basis points year over year to 55% mainly due to continued increases in TACs and growth in hardware. Operating margin, excluding the EC's fine of $5.1 billion, came in at 24%, down approximately 230 basis points from last year, due to lower gross margin and continuing increase in headcount. We estimate that Alphabet's further investments in R&D and more content acquisition and creation for YouTube, likely will keep full-year operating margin in the 20%-23% range through 2022.

As noted earlier, the EC imposed a $5.1 billion fine on Alphabet's Google claiming that it forces mobile device manufacturers to bundle Google apps such as Chrome and Google Maps on their phones as default apps. According to the EC, this restricts other mobile browser and app developers to compete. In addition, the EC would like Google to allow device makers to further customize the Android operating system. While Alphabet recognized the fine in the second quarter as an expense, the firm will be appealing the EC's decision. In our view, whether Google forces OEMs to pre-install its apps or not, consumers will continue to download and use Google apps as they have been working well for a long time. While there are no switching costs for consumers, we believe the network effects of most of those apps will remain, especially given Google's improvement of its machine learning technology which continues to enhance search results. As a result, we expect demand for the apps to continue to grow, forcing OEMs to place them on their devices as default, whether forced by Google or not.