Paypal and Alphabet Spell it Out for Investors

Two big heavyweights of the tech industry, PayPal (PYPL 0.14%) and Alphabet (GOOG -0.29%) (GOOGL -0.41%), reported their fourth-quarter results earlier this month, and Motley Fool analysts Dylan Lewis and Sarah Priestley have dug through the reports.

In this episode of Industry Focus: Tech, they share the most interesting points from both reports, from the most important earnings numbers to little Q&A gems that shed some light on each companies' long-term plans, and more. 

A full transcript follows the video.

This podcast was recorded on Jan. 27, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Jan. 27, and we're breaking them quarterly results from PayPal and Alphabet. I'm your host, Dylan Lewis, and I'm joined in the studio by fool.com tech editor Sarah Priestley. Sarah, how's it going?

Sarah Priestley: It's good, it's a pleasure to be here, thank you for having me.

Lewis: Are you excited for pizza day?

Priestley: I am very excited. It's going to derail my New Year's resolutions, but that's OK. [laughs] 

Lewis: That's a callback to your episode with the Vincent Shen. Are you finding that the Apple Watch is being helpful?

Priestley: Yes. It's definitely reminding me at 9 p.m. that I have done 0 steps, so I just end up walking around my living room like a crazy person.

Lewis: I do that when I'm on the phone all the time. That's how I get my exercise in.

Priestley: That's probably a good idea, yeah.

Lewis: So, Sarah, a ton going on in tech this week, the next couple weeks with earnings. Two pretty followed Fool companies reported yesterday after the bell. We dug into the reports and are ready to talk about them. You did some of the heavy lifting with PayPal; I dug into Alphabet. Why don't we talk about PayPal first. How did the results look?

Priestley: To give you an overview for the fourth quarter, earnings came in at $0.42 per share. $2.9 billion in revenue. Operating revenue was a little higher than expected at 21%. Transactions were $1.8 billion. But the volume was below expected. Expected was $100 billion and they delivered $99.3 billion. And that is why share prices are down about 3.5% this morning. So, it seems like a slight overreaction when you dig into their numbers. But, yeah, that's the reason for the share price falling.

Lewis: And that's really one of the core metrics that investors tend to focus on for them as a company, right?

Priestley: Absolutely. They really are measured on engagement, so number of customers, and engagement of those customers, and the key metrics for those.

Lewis: Looking beyond some of the top line numbers, what else popped up to you in the report?

Priestley: The operating margin for the fourth quarter was down to 15.4%. The reason that we're commenting on this is that that's a lot, it takes up a lot of room in the bullish theses, that the new partnerships they've started with a lot of the banks, Visa, Mastercard, they're going to really pressure their margins down.

Lewis: Is the thought there that they're working with very big institutions and big players, and they just don't have the negotiating room that they might with some smaller players? 

Priestley: Absolutely. That's part of it. And also, it's just the standard transaction payment. It's the same thing for Square and other payment processors; it's a standard transaction amount on card processing. So, that 15.4% compared to 16.1% in the fourth quarter of last year -- you can see, that's quite a decline there. Management has talked about the fact that they are really doing everything they can to leverage their other income against this. And I feel like they've done a pretty good job. Their CEO, Dan Schulman, has said that they won't be a slave to quarter-to-quarter margin performance.

Lewis: Which is something we like to hear as Foolish investors.

Priestley: That's very true. And, I would also comment that the management team is really being driven for their compensation package on the long-term performance of this stock, and I think that really shows in their reporting. They're focused on free cash flow in their projects, and what they're delivering to their customers. Just to give you a couple of the year-over-year figures: Earnings per share for the year increased 15% to $1.15. Non-GAAP was $1.50 on guidance of $1.45 to $1.50. That's pretty good. Revenue for the full year was up 17%, and 21% on a currency-neutral basis, and they guided for 19%, so they really beat that.

Lewis: Like Alphabet, their fiscal Q4 comes with the calendar Q4, so we were able to look at full year results here, and not just the quarterly results. What's going on with total payment volume? I know that's something that people really like to focus on with them.

Priestley: Yeah, absolutely. If we had seen total payment volume less than 25%, I think we would have seen a bigger decline in the stock price. Luckily, for the fourth quarter, payment volume was up 25%. As I said, the actual processed amount was $99.3 billion, which missed the expectations. Interestingly, the majority of this was pushed by international. International expanded 27%. The U.S. was 23%. 

Lewis: And for the unacquainted, total payment volume is just the gross amount that they are helping to facilitate.

Priestley: Yes. The way to look at this is, the total payment volume is the number of payments that they process. Then, the transaction is the amount that they process. So, they're averaging about $56 per transaction right now. That's slightly down from $60 that they were averaging a couple quarters ago. But it's still very good.

Lewis: So, for the amount per transaction to be down, they must be doing more total transactions to be making it up in volume and still be seeing growth, right?

Priestley: Yes, you're exactly right. I will also comment that, of their transactions in their Q4, $100 billion was mobile payments, which is an increase of 55%, and it's almost a third now of their transactions processed. Which is fantastic, and I think the management team has really isolated that as an opportunity for the company. That's where they're going to really demonstrate their industry leadership. The market is moving toward mobile, and they're really pioneering in the mobile industry.

Lewis: So what can people expect looking forward, either first quarter of 2017 or further out, broadly in 2017?

Priestley: Absolutely. I'll look for 2017 quarter four revenue we're expecting to grow on a currency neutral basis 16% to 18%. That gives you a range of $2.9 billion to $2.95 billion. That was actually slightly more conservative than some analysts were expecting, which played into their share price performance today. But full-year performance is strong, revenue growth 15% to 17% and 17% to 19% currency neutral, which gives you about $12.45 billion to $12.65 billion.

Lewis: Is there anything to worry about with some of these numbers that we're looking at, that management growth projections are different than what the market is expecting? Because, they are still very much in growth mode as a business, and I know that early on, those projections, if they start to decelerate at all, can start to scare people off a little bit.

Priestley: I think they have been fairly conservative in some of their estimations, because they really do have a huge potential with the mobile traffic. I think, if you look at some of their projects that they're working on now, Venmo has increased 100% year over year. It was Time Magazine's best app, it's processed $5.6 billion, which was up 126%. So, I think they have a huge potential with a lot of the projects they're working on; they've experienced huge growth. The problem with these is that they are not monetized yet. And an analyst actually raised the question in the earnings call: "Is your projection in 2017 building in some of the expectations for monetizing this, and also Xoom?" which is their international money transfer program. They dismissed this. They said it was pushing out to 2018, some of the opportunities, and that they will be focused on growth. So, I think, for 2017, these might be conservative estimates. But for 2018, we might actually start to see the fruits of that labor.

Lewis: Yeah, and you said, 55% of what was being processed, broadly for the business, was coming from mobile. When you look at Venmo specifically, that is almost entirely mobile. It's more peer-to-peer. There are some questions about whether or not they will be able to monetize that very well, and what that might look like, because me giving you $5 because you bought me lunch the other day, they don't really take anything on that.

Priestley: No, they don't. And something to say is, it's becoming a hugely crowded market. I think PayPal, to some degree, has a first-mover advantage, but they're definitely not the biggest player in this industry. The banks have gotten together and created clearXchange, which is a peer-to-peer payment which is also free right now. It's owned by the banks, so it has a lot of clout. Whether or not people pick it up to the rate that they've picked up Venmo, which is hugely popular with millennials, a lot of our friends use it all the time, we use it. Also, Apple. Apple has grown hugely. Tim Cook in his last earnings call -- so, this is a bit outdated -- said that 75% of swiping transactions were from Apple Pay.

Lewis: Wow. It's hard to believe. Anecdotally, though, when I'm out with my friends, and maybe you can lend some color on this too, if someone covers the tab, I'm paying them via Venmo. No one is ever like, "Do you have Bank of America mobile payment processing?" So, they do seem to have that first-mover advantage, and I think they have that name recognition. When you have that huge installed base, as they do, it really comes down to whether they can flip the monetization switch on. I guess investors are going to have to be patient on that, if management is pushing that out to 2018.

Priestley: Absolutely. I will say, they do have a lot of initiatives that are panning out for them right now. One Touch basically enables you to fill in your bank details, and you work through PayPal, and you can just click one button at the checkout and it's transacted through PayPal, which is hugely beneficial for mobile. I don't know about you, but frequently, when I'm  looking at shoes online, as soon as I get to the card payment, and you have to zoom in on those small boxes and put your card numbers in, they lose me. I think it's something like a 74% cart-abandonment rate on mobile.

Lewis: So when people reach that checkout phase and they see that they need to drop in their credit card number, their security code, their address, shipping address, zip code, all that stuff, they wind up ditching it?

Priestley: Absolutely. But, PayPal One Touch, they have 87% conversion rate on mobile. That's incredible. They've had a lot of people starting to use that. They have added a lot of One Touch users. And, I think, of their merchants, about one-third right now are on One Touch. And they just launched this last year. So there's a huge potential here for them to really deliver on their promise. They've said they want to make customers' lives easier, and they're doing that, absolutely.

Lewis: Anything else that management provided color on with the business, and strategically where they're looking, that investors should know?

Priestley: I think the focus is absolutely on mobile. Dan Schulman has definitely commented on the fact that mobile is the biggest opportunity for them, and there are a lot of industry tailwinds that they're experiencing right now. And I would completely agree. I think Black Friday this year was the biggest online shopping day in history. In quarter three last year -- we're still waiting for quarter four -- the Census Bureau said that online retail made up 10% of all retail transactions. So you can see that if they are positioning themselves well to benefit from this, it should be a rising tide that lifts all boats.

Lewis: I know they've talked a little bit in the past about continuing to be an asset-light business. Is that something that management recommitted to in the most recent call?

Priestley: Yeah, absolutely. This is something that analysts have been focusing on. I definitely noticed a couple of questions about this in the earnings call. Square offers capital, it offers loans, as part of its services. It's not a huge part of their business, but it is a risk area of the business. So, in the fourth quarter, they had $123 million loss on loans. As a service similar to the company Square, which deals mostly with small businesses, but obviously this is individuals, PayPal has access to a lot of people's information and their spending habits and how much money they have. So they want to really leverage that information, and offer it out to partners to facilitate the loans using their information, which takes the risk away from PayPal, but they're still generating a percentage of income from it. So, overall, Dan Schulman commented that it's a really competitive environment for this. I think the payment space is just getting more and more competitive, every angle of it. But overall, I think this is definitely a good move for the company. It's the right decision, it's going to eliminate some risk. But it's also potentially going to bring in a degree of revenue too, if they can grow that segment.

Lewis: So, it seems like the general takeaway here is: Wait and see with a lot of the company's mobile initiatives. The core business seems to be humming along. There was a little bit of disappointment, but nothing thesis-altering, nothing crazy in the report.

Priestley: No, absolutely not. And they didn't touch too much on some of their partners. They've had some really high-profile partnerships with Alibaba, Vodafone in the U.K. and Europe, and many others; Discover, that they recently announced. They didn't touch on that too much, so we can't really give investors a good flavor for how that's going, only that it's in line with their expectations. So, yeah, I agree with what you said. I think mobile is going to be a big area of focus, we'll continue to have a look at those transaction volumes and customer engagement.

Lewis: So Sarah, I said that you did the heavy lifting on PayPal. I did most of the homework with Alphabet's earnings. I'm going to flip it over to you and let you host for the second half of the show.

Priestley: It's really nice to not be in the hot seat. [laughs] 

Lewis: Yeah. I'll stop firing questions at you. It's my turn.

Priestley: So, yeah, Alphabet reported the same time, yesterday after the bell. What were the results?

Lewis: Overall, Alphabet's revenue came in at about $26.1 billion for Q4, up 22% year over year, which beat analysts' estimates of $25.3 billion. Earnings per share came in at $7.56, slightly lower than analysts' projections of $7.63 per share. I think the real story -- and what caused some of the immediate reaction for the stock -- was that adjusted profit missed by much more. That came in at $9.36 a share, versus expectations of $9.64 a share. We saw, after hours, the stock was down about 2.5% to 3%. That's what most of the market seemed to really fixate on.

Priestley: And what was the cause of that?

Lewis: Tax rate, basically, is the short of it. In Q4, Alphabet had an effective tax rate of 22%. They also highlighted their broad 2016 tax rate, because they're able to report whole fiscal year results as well. The company's effective tax rate for the year was 19%. That's a big bump. And you realize that average is also incorporating other quarters. You can get a sense of how much more they were paying out in taxes this quarter. Really, if you want to get down to the nitty-gritty, MarketWatch writer Jeremy Owen does a really good job breaking down the specifics, but the gist of the issue is, the Financial Accounting Standards Board issued some changes a while back, basically impacting how companies can treat stock-based compensation for their adjusted earnings numbers. And that wound up impacting results for this quarter. Moving forward, the company will no longer be excluding stock-based compensation expenses from their non-GAAP results, which should smooth things out. But they wound up dealing with a little bit of a hiccup this quarter to reconcile.

Priestley: Yeah, that's really unusual, the change for GAAP there.

Lewis: Yeah. Typically, you think of non-GAAP numbers as being something where the Financial Accounting Standards Board gives people a decent amount of latitude to operate how they want to. But they like to rein things in every now and then, specifically with stock-based compensation because it's something that a lot of firms use to make their non-GAAP numbers look quite a bit better than their GAAP numbers, especially in the tech space. Looking at a couple of the different segments, their Google segment, which is search, ads, Android, Maps, Chrome, YouTube, pretty much anything that falls under their internet properties, came in at $25.8 billion. So, looking at a company with $26 billion in quarterly revenue, that's the meat of it right there. That is generally performing pretty well. Their Google Sites segment, which is the majority of that, was up 20% year over year. Network revenue up 7% year over year. Other revenue, which is a smaller portion a little bit less related to the internet properties within that segment -- think Hardware, Google Play, and their cloud segment -- was $3.4 billion, which was up 62% year over year. So, that's a very fast-growing segment within Sundar Pichai's Google area of the business.

I think, if you're looking for indicators for them, the two big ones that tell the story for the ad business and what's going on with some of the internet properties: Aggregate paid clicks, which is basically the number of times that people are interacting with ads online, was up 36% year over year. Aggregate cost per click, or CPCs, as they're commonly known, was down 15% year over year. This is not really a surprise. This is a story that's been playing out for a long time. We talked about the shift to mobile when we were talking about PayPal. The same thing is happening with internet search. CPCs have been driven down because the effectiveness of mobile ads isn't necessarily quite the same as it is for desktop. But for the longest time, Google has been able to make it up on volume. There's actually quite a parallel there with what happened with PayPal and the volume making up for the smaller transactions. We're seeing the same effects here with Alphabet.

Priestley: Would you suggest that's something that investors should include in their thesis going forward?

Lewis: I think it's something that, at this point, we shouldn't be too surprised by. This story has been playing out for a decent amount of time. If it really accelerates, you might have to worry. But they have been very good at making the volume make it work out. Eventually, mobile will need to find a floor somewhere, and enjoy that. But so long as we're still in that transition to mobile, I think we're going to continue to see this for a while, unfortunately.

Priestley: OK. What about the Other Bets segment? I know there have been some interesting moves this year.

Lewis: Yeah, this is something that people love to ask about, because it's like, "Where is Google wasting all of this money?" As a reminder, this is basically all the stuff they do that isn't tied to their internet properties. Think of it as their moonshot projects. The big financial contributors for this segment are Nest, Fiber, and Verily. They tend to focus on a full-year breakout for the segment because the numbers are so small relative to the overall business. But revenue came in at $809 million for 2016, which was up 82% year over year. Operating loss not including stock-based compensation was $2.9 billion, down slightly year over year. But, this segment is still a money pit for Alphabet, and I think it will continue to be. They have reined in costs a little bit under CFO Ruth Porat. I think she has forced all of the Other Bets initiatives to at least be able to show a path to monetization, or a road map to what that might look like. But I think there's a certain test-and-innovate atmosphere that they want to maintain. And investors have been OK with that, because their core internet business just prints money for them.

Something that is interesting with them and the Other Bets segment is, they spun out Waymo, which is their autonomous driving segment. For the longest time, that was the Google Self-Driving Car Project. A couple months ago, they said, "This is a stand-alone business unit, and it will be nested within the Alphabet holding structure. It will continue to be in Other Bets." And we didn't get any financial insight into what's going on with that. But they talked about it in the call. Ruth Porat provided some commentary on what they're basically doing with Waymo as a blueprint for what they will continue to be doing with Other Bets. Not a ton to report there, but this is something that Daniel Sparks and I talked about in a podcast when they announced that a few months ago. As we, in the next couple quarters, over the next year, continue to get more information about Waymo, I think we can look at that specific business segment and see the path for what's going to be going on for some of the Other Bets as they continue to mature and eventually see monetization. So, not a ton to report with Other Bets stuff, but at least we have something that we can start to track for what the company's ambitions might be.

Priestley: Absolutely. It looks like they're moving forward with that. Was there anything else in the numbers that stood out to you in the earnings call?

Lewis: I think some of the things that people need to keep in mind with this report, because the stock was down after hours, I think as of taping this morning, they were down 40 or 50 basis points, so not a crazy reaction like 3% that we saw after hours yesterday, but still down, I think people might be scratching their heads a little bit with some of the tax stuff they saw. Prior to the report, the company was trading at all-time highs. It's traded up for a while. I think it's somewhere in the teens in the last year or so. So, there's that. And also, Alphabet does not provide detailed quarterly guidance. Most companies do offer up that guidance, and analysts create their own models based on those numbers, those line items, and they have their puts and takes to tweak it slightly. But because Alphabet doesn't give those baseline expectations, the likelihood of actual numbers being different than analysts expectations is slightly higher than it would be for other companies. So, the market's reaction is always, I think, generally going to be a little bit sharper than what we might see for a company that does offer standard guidance.

Priestley: Yeah, because they have nothing ready to peg their estimates to.

Lewis: Yeah. They have the general trend of things and what they can glean from commentary. But very often, you'll see analysts' expectations more or less mirror guidance with slight adjustments. Not having that as a crutch can just add some unpredictability to things. I think that's the way you have to think about it.

Priestley: Any other little gems?

Lewis: Outside of the numbers, something that caught my eye that I think is a great point, and really underscores the importance of reading company conference calls, and not just relying on the numbers that you see reported and the quick earnings takes you'll see online: Mark Mahaney from RBC Capital Markets in the Q&A section of the call asked this really great question, and I think it points to a looming risk for Alphabet, and I just want to highlight that for listeners. He said, "It looks to me like Google devices are being outsold 10 to 1 or something like that in most homes. It's immaterial now, but you could see you in five years there's a new voice search interaction interface and it's not Google in the home. That could be a real challenge for the company." And he was basically positing, "What are you guys doing about all of the virtual-assistant and smart-home devices?"

Priestley: Yeah, great question.

Lewis: Yeah. And Sundar Pichai, Google CEO, he gave that generally positive answer, talking about the investments the company is making and how they're working toward voice search, and how they're trying to meet consumers in every situation that they might be using voice search, whether it be phones, TV, homes, cars, whatever. But really, at its core, Mahaney's question is getting at this idea of: Amazon's Echo devices are selling like hotcakes. If the installed base for them, or really any other virtual assistant, gets massive, and consumers start using those devices for the types of things and the purposes that people are generally using Google mobile and desktop search for, what does that do for your business? I don't want to be alarmist with any of this. I am an Alphabet shareholder, I really love the company. But I think he makes a good point. Earlier this month, actually, at an ad industry conference, there was an Amazon VP talking about some of the capabilities and some of the opportunities that Amazon might explore. That led some analysts to speculate that the company might be interested in exploring paid search with its Alexa product. This is not something that is a next-quarter, next-year issue. But over the next five to 10 years, we need to keep an eye on how people are using search, and how people are using home assistants or virtual assistants. Because, if we see that slowly eat into what would otherwise be desktop or mobile search, you have to wonder about how that might impact Google's core business, and really what prints money for them and allows them to fund all of these other projects.

Priestley: Yeah. And also, which products they're using. If everybody starts adopting the Google Nest, then they're good.

Lewis: Yeah. If people are using Nest or Google Assistant, then yeah, not a huge problem, that will keep them within that ecosystem. If they are using products that don't lean on Google search, and you have platforms that are able to monetize that search, Google might get crowded out a little bit. Again, Google did $26 billion in revenue this quarter. The vast majority of that was online ads. It's a huge market. I think people's more in-depth searching, or more research-based stuff, is always going to be on desktop or mobile. You can only glean so much from audio. But if you want the quick answer on something -- say you want to know who was the fifth president of the United States -- you can find that out with a voice search, and not really have to worry about being on mobile or desktop. And that's less impressions for Google Ad Search. So, it's something to keep in mind. Again, this is a five, 10-year risk. But, just, investors, keep an eye on what's going on with the virtual assistant market, because it's something that could impact Alphabet down the road.

Priestley: That's really interesting. I will hand the baton back to you. [laughs] 

Lewis: Oh, you're going to let me wrap up? That's so magnanimous of you.

Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say "hey," shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Sarah Priestley, I'm Dylan Lewis, thanks for listening and Fool on!