This "look-ahead" post discusses how I came up with an estimate for Alphabet's earnings for fiscal 2020's fourth quarter, which ended on December 31, 2020, by predicting each element of its Income Statement, from top-line Revenue to bottom-line Earnings Per Share (EPS) and everything in between.
Once the company’s official results become available on February 2, I will compare the published Income Statement to the prediction and identify any surprises, positive or negative. Examining these differences can identify what factors (e.g., profit margins, non-GAAP expenses, tax rates, share buybacks) are driving changes to a company's financial performance.
But, before getting into the details, let's take a step back and start with background information about Alphabet.
Alphabet was formed in 2015 as the holding company for Google and various smaller businesses known as "Other Bets." Alphabet has three classes of common shares, with Class B shares, which are primarily owned by Google's founders, having much greater voting rights than the Class A (ticker GOOGL) shares. Class C shares (ticker GOOG) have no voting rights.
Google's products include Search, Maps, Gmail, Android, Chrome, Google Cloud, YouTube and (recent acquisition) Fitbit. Even though Alphabet also controls businesses such as Calico, GV, Verily, Waymo, and X, Alphabet's revenues are almost entirely due Google's ability to deliver online advertising. Google (and, therefore, Alphabet) has been benefitting as commerce moves on line, and the COVID pandemic has accelerated this trend. But, Google's strength can also be a concern. In October 2020, the U.S. filed a civil antitrust lawsuit claiming that Google has abused its market position in the search and search advertising markets. This follows a decision by the European Union in June 2018 to fine Google 4.34 billion euro ($5 billion) for abusing the dominance of its Android mobile operating system. One year earlier, the EU fined Google €2.42 billion ($2.74 billion) for violating European competition law in the way shopping search results and ads were displayed.
Shares of Alphabet now trade for about $1728 each, giving the company a market value of $1.2 trillion. These shares can be found in the Standard and Poors 500, NASDAQ 100, and Russell 1000 stock indices.
Alphabet recorded profits of $36 billion on revenue of $172 billion during the last year. In the quarter that ended on 30 September 2020, Alphabet earned $16.40 per share, which matched the $16.40 Wall Street consensus forecast. See https://tinyurl.com/y5u7dq2l for Alphabet's most recent quarterly report.
Revenue in the September 2020 quarter totaled $46.2 billion, 14 percent more than last year's $40.5 billion. The Google Search business was responsible for 57 percent of overall revenue, and this unit's revenue grew by 6.5 percent compared to the year-earlier result. The YouTube Advertising business contributed 11 percent of revenue, and this unit's revenue increased by 32.4 percent. The Google Cloud unit supplied 7 percent of revenue, and the value rose by 44.8 percent.
My starting point, if available, when estimating earnings is guidance provided by the company's management to financial analysts. It's true that the company may downplay expectations somewhat to avoid disappointments, but the top managers ought to know better than anyone else how well their products and services are selling. I also look for other information about the company in the news, and I take advantage of trends in the company's historical results. While it makes my task a little more difficult, I also try to estimate earnings that conform to Generally Accepted Accounting Principles (GAAP). Non-GAAP results, which most professionals focus on, are somewhat arbitrary and often exclude meaningful items.
Alphabet described its expectations for the fourth quarter of 2020 in October after the company last reported quarterly results. Here are some of the most salient statements:
Let me end with our outlook. Regarding revenues, in the third quarter, we benefited from a broad-based improvement in advertiser spend across all geographies and nearly all verticals. This is reflected in both Search results as well as the rebound in brand advertising spend on YouTube. While we’re pleased with our performance in the third quarter, there is obviously uncertainty in the external environment. In terms of Google Cloud, we’re pleased with the consistent strong revenue growth that you saw again this quarter, reflecting the extraordinary secular trend under way. And, with respect to Other Revenues, the primary driver of growth was Play, where revenue growth reflected elevated engagement during the pandemic on top of strong underlying growth. There are signs that user behavior is beginning to return to normalized levels.
Moving on to profitability. We are pleased with the improvement in profitability versus the prior quarter, reflecting both the revenue performance versus Q2 as well as the tactical adjustments we made to slow down certain categories of spend in response to COVID. In particular, the deceleration in headcount growth this quarter reflects the actions we took at the outset of the pandemic to focus hiring on our highest priority areas like Google Cloud. Excluding the impact of closing the pending Fitbit acquisition, we expect a moderate further deceleration in the pace of headcount growth in the fourth quarter.
We also saw the impact of steps we took to slow down some categories of marketing spend. In the third quarter, Sales and Marketing expenses declined year-on-year, primarily due to a planned slow down in ads & promo. We expect a more moderated year-on-year decline in Sales & Marketing in the fourth quarter as we increase spend sequentially to support product launches and the holiday season.
Turning to Capex, once again this quarter, we had a year-on-year decline in investments primarily due to a reduced pace of real estate acquisitions which we implemented at the outset of the pandemic. Servers continued to be the largest driver of investment in the third quarter, followed by data centers. Our Capex outlook for the full year has not changed as we continue to expect a modest decrease in 2020 compared with last year.
(emphasis added)
My takeaways from this guidance are as follows:
- Maintaining the revenue growth rate for Advertising, which is the preponderance of sales, depends on how the economy holds up during the pandemic. Cloud revenues will continue to grow, revenues from lesser sources may moderate
- Margins will improve, but by small amounts, due to less hiring
- Sales and marketing expenses will fall, but not by much.
- Capital expenditures will neither accelerate nor decelerate.
Revenues increased by 14 percent in the third quarter of 2020 relative to the year-earlier period. Economic data for the fourth quarter isn't yet available, but data for October and November showed small declines in personal income and consumer spending. I'm going to assume Alphabet's revenue growth slipped to 11 percent.
The gross margin was 54.3 percent in the third quarter of 2020 and 54.4 percent in the fourth quarter of 2019. I decided to go with 54.5 percent for the latest quarter.
Research and development spending has been about $6.8 to $6.9 billion per quarter in 2020. The figure is normally somewhat higher in the fourth quarter, $7.4 billion seems like a reasonable estimate for the fourth quarter of 2020.
Sales, general, and administrative expenses have been about 17 percent of revenue, but often higher in the fourth quarter. I've chosen 17.5 percent of revenue for my estimate.
Alphabet's income tax rate was about 16 percent the last two quarters, although it was quite variable in the preceding periods.
The resulting estimate for Net Income is $10.9 billion ($15.88 per share).
The following Income Statement summarizes the estimates made as discussed above.
Please note that my organization of revenues, expenses, gains, and losses, which I use for all analyses, can and often does differ in material respects from company-used formats. The standardization facilitates cross-company comparisons.
#alphabet #google #googl #goog #gauges #gcfr #gcfr2 #lookahead #nac_financialanalysis
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