On this Industry Focus: Tech episode, host Dylan Lewis and two of The Motley Fool's awesome summer interns, Aneesh Susarla and Connor Lott, dive into the earnings reports for both companies. Find out what trends in these reports were important enough to move these behemoth companies' stocks, where Facebook and Alphabet are seeing the majority of their growth, some of the biggest risks that both companies are facing in the next few quarters and years, a few key takeaways for potential investors, and more.
A full transcript follows the video.
This video was recorded on July 28, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 28, and we're talking big tech earnings. I'm your host, Dylan Lewis, and I'm joined in the studio by Fool interns Connor Lott and Aneesh Susarla. What's going on, guys?
Aneesh Susarla: Hey!
Connor Lott: Hey, Dylan!
Lewis: So, you guys are wrapping up your last week here at Fool HQ, right?
Lott: We sure are, yeah.
Lewis: What would you say has been the highlight of the summer, being here?
Susarla: The highlight has definitely been my final stock pitch yesterday. Got a great amount of feedback from the investing team and it went really well. I pitched an exciting biotech company.
Lewis: Exciting biotech company? You have to talk to Healthcare host Kristine Harjes about that.
Susarla: Will do.
Lewis: What about you, Connor?
Lott: I would say Bonchon was the highlight. [laughs]
Lewis: All right! The IF listeners know the lore of Bonchon quite well; we spent a lot of time talking about it on the podcast. But for people who haven't caught it before, it is bliss: double-fried Korean chicken wings.
Lott: I'm a believer now.
Lewis: Did you go spicy or mild?
Lott: Both. I tried the whole shebang and it was glorious.
Lewis: You did all right. What else was glorious: some tech earnings coming in. It's about time! It's awesome to have some fun new numbers to look at on the podcast.
Why don't we start out talking about what we saw from Alphabet this quarter? This is Google's parent, one of the first big tech names to release earnings this quarter. Looking at the results, the company posted $26 billion in revenue, up over 20% and beating expectations by a few hundred million. EPS was a little fuzzier for the company. They had some one-time items that caused some issues with that metric. Excluding those, EPS came in at $8.90 per share, beating estimates. Of course, the company had to recognize that one-time item, the $2.7 billion charge after being fined by the European Commission for some antitrust practices which brought actual EPS down to $5, also beating expectations. All that said -- all those great top-line and bottom-line numbers -- shares actually took a 3% dip. What were some of the issues that the market was seeing in these results, guys?
Lott: I think there's a couple metrics that analysts were looking for to continually improve over the next couple quarters, and they were soft, a little bit. CPC, cost per click, which is an important metric that reflects how much Google gets for ads, was down 23% year over year, and 6% quarter over quarter. That wasn't measuring up to what was expected. Additionally, traffic acquisition cost, or TAC, amounted to $5.09 billion, which was higher than analyst projections of $4.75 billion, which is up to 22% of advertising revenue from 21% a year ago. Basically, CPC, which should be up, went down; and TAC, which should be down, went up. So, it's not entirely worrisome right now for Alphabet, but analysts are looking a little bit down the road and saying this could impact the enormous revenues that are coming in from Google.
Lewis: The CPC story is one that's been playing out for a while. As the company, and really the world, transitions to mobile browsing rather than desktop browsing, we've seen CPCs come down. I think analysts were expecting it to be somewhere in the teens as it dropped, and instead it came in at that 20% figure. So, I think that's why you see some of that reaction. The flip side of that, and why the company has been able to continue to grow that top line, is because more people are connected; it's easier to just have a phone or something like that, and be on the internet. The company has been able to make it up on volume for quite some time.
Susarla: I think you really characterized that perfectly. When more people are continuing to use mobile devices for browsing, Google is really going to have to figure out how it can continue to drive revenue growth and ensure that advertisers are best characterized with mobile revenue.
Lewis: Yeah. So, I think some of those concerns are warranted. I am a believer that they will figure that out, as the ad giant, and probably one of the two biggest sources of digital ad spend. I'm not too concerned about it, but definitely something to be mindful of. The reason that it's such a concern is, looking at how Alphabet makes its money, $25.8 billion in revenue of that $26 billion figure [is] coming from Google and the internet properties. So, it's understandable that people are a little worried about that CPC trend.
One of the other main properties that there was a lot of attention paid to on the call was YouTube. It seems like every conference call, I'm hearing more and more about what's going on there.
Lott: Yeah. Google CEO Sundar Pichai did say that YouTube generated over 1.5 billion monthly viewers, and made an extremely hot market for video advertising. So, it should be Alphabet's second-largest revenue-generating enterprise, after Google's core internet search business. We say "should be" because they break it out between Google and Other Bets. So, they're very non-transparent, or opaque, you might say, in delving into what is actually making money for them. YouTube, with its 1.5 billion monthly viewers, if it were categorized as a social network (as, say, Facebook), it would be the second-largest social network in the world.
Lewis: Which is baffling.
Lott: Yeah, it's incredible.
Susarla: I read this interesting report that said, if YouTube was a stand-alone business, it would have a market cap of around $75 billion, which is pretty insane. So, definitely, YouTube can serve as a driver for growth.
Lewis: Some of the other places that Alphabet has been looking for growth is the Other Bets segment, which makes up the rest of that pie chart of revenue. Right now, it is just under $250 million. We always hope to get some really interesting color on what's going on with these futuristic, nascent tech bets that Alphabet's making. Unfortunately, it's always kind of a disappointment. We didn't really get a ton with this call, right?
Lott: Right. Just a fun fact that we're going to throw out here, because we're on the YouTube trend right now. Aneesh, what do you think the most viewed video on YouTube is?
Susarla: I would say "Gangnam Style," the PSY music video.
Lott: Up until early 2017, late 2016, you would have been right. Now it is Wiz Khalifa's "See You Again." So, Wiz is making it happen on YouTube.
Lewis: I wonder with stats like that: Those are not songs that have longevity; they are pop tunes. I wonder, if some of the really seminal rock songs came out in the digital age, where they would stack up, because it's an unfair comparison.
Lott: It is. You would think Queen or AC/DC or some enormous band, Led Zeppelin, would be the king of the hill. But, no, we have Wiz Khalifa, with Luis Fonsi's "Despacito" garnering 2.8 billion views in like six months.
Lewis: It's on your heels; watch out.
Lott: Yeah, it's coming in hot.
Lewis: That's the song of the summer. I've heard that everywhere.
Lott: They are not going despacito, they're definitely not going slow.
Lewis: No. It's muy caliente, I guess. Looking at these results, I don't see anything super thesis-altering with Alphabet. It's a massive company. At this point, it's tough for them to meaningfully move the needle and grow the business. I don't think this is a stock or a business that's going to be a two- or three-bagger any time soon, simply because it's a $660 billion market-cap company. But, when you look at this business, the internet properties that they own are so strong. The fact that they are posting 20% growth with this ad business is amazing. The fact that they have 1.5 billion monthly actives on YouTube, also amazing.
I kind of look at what they have here with this cash-cow business, and then this Other Bets segment as a stable business and a mini VC [venture capital] fund. You have these bets like Loon, which is all about connectivity; Verily, which is all about life sciences; Nest, which is connected-home; Fiber, which is all about broadband; and Waymo, which is all about autonomous vehicles. These are all emerging tech plays, and if any of those take off, that's where you could see some really explosive growth. Of course, the core ad business is still moving along fine.
Did I hit it? Do you guys have anything else?
Lott: I think you hit it right on the head. Just looking at Waymo by itself, that's already changing the automobile market with self-driving cars. So, yes, if one of these properties takes off and really revolutionizes its vertical, that could be incredible for the company.
Lewis: Yeah. I think it's not a stock to own if you want gaudy tech growth, but if you're fine with chugging along and maybe having some really awesome plays in these nascent tech spaces, certainly a stock to continue to watch.
If Alphabet posted good numbers and got a pretty meek response from the market, I think Facebook had pretty much the opposite. Great numbers and, wow, up 5% immediately after posting the next morning. Great results here. Do you guys want to walk through some of the numbers a little?
Susarla: Yeah. Facebook continues to be a wonderful story when it comes to social media growing and taking over the whole space. The company reported revenue of $9.3 billion, which was good for 45% growth and beat expectations pretty handily. On the bottom line, net income clocked in at $3.9 billion, which is up 70% year over year. You don't see that for a company that has a market cap greater than $500 billion, so that's super impressive. Operating margin was up 500 basis points to 47%, thanks to revenue growth outpacing spending. That's a pretty huge swing, so that will definitely be an indicator to look for in the future. Particularly, mobile ad sales hit $8 billion, which was a 53% increase.
Lewis: Looking at that number for a second, you see that $8 billion comes in at a massive part of the overall $9.3 billion revenue they're posting for the quarter. They, too, are seeing that mobile pivot, and doing it very successfully.
Susarla: Yeah. Mobile ad revenue now accounts for 87% of their total ad revenue. In the past, we heard so many concerns about whether or not Facebook would be able to transition to mobile and continue to generate revenue from there, so that's super impressive. Another good indicator is that the price of an individual ad rose 24%, and the total number of ads rose by 19%. Even though the company signaled that the ad space in the News Feed is reaching upper limits, they're still continuing to grow, so that's pretty positive. Additionally, the company still makes most of its ad revenue from those in the United States and Canada, just because they're more developed markets. But it's looking to continue monetizing more of its international markets. Currently, the average revenue per user worldwide is $4.73, which was a 50% jump from the first quarter of 2017.
Lewis: I want to circle back on what you talked about, with looking forward in growth, in a little bit. But before we get over to that stuff, if we're talking Facebook, we also have to talk user counts. I think that's one of the easiest ways to see the trajectory of a social-media business. You look at the response with Twitter (NYSE:TWTR) today, after reporting earnings and showing absolutely zilch for user growth --
Lewis: -- you can show how much the market fixates on that. So, what are we seeing with users, Connor?
Lott: Right now, the platform has two billion monthly active users, with 1.3 billion daily active users, which obviously makes it the preeminent social network in the world. Then, looking at the different properties in terms of advertisers on those properties, Facebook now has five million advertisers. Instagram -- which is owned by Facebook -- has one million by themselves. They've grown incredibly over the past five to 10 years since the formation of the company, in terms of driving at growth and in terms of MAUs and DAUs. It's a really encouraging sign that they can now really see those profits take over from that base growth.
Lewis: Yeah. I think that advertiser at a glance is good, because you don't get a good breakout of what's going on, what's coming from Facebook and what's coming from Instagram. Getting a sense of how many advertisers they have participating on each at least gives you kind of a baseline feel for, maybe, what those revenue contributions might be. We talked about the growth deceleration. Facebook's management has talked about the growth deceleration. They've tried to signpost this as much as possible. I think part of it is, it's really tough to keep putting up these ridiculous numbers. You look back to what they've done, Q3 of 2016, which they'll be going up against, they posted 55% revenue growth, and that's really tough to do. Part of the equation, though, looking at the way the business works, is they're hitting us some saturation with their ad load.
Susarla: Right. There's only so many ads you can include in the News Feed, simply because as users scroll on videos, they'll spend a certain amount of time there, and you don't really want to compromise the user experience by including a ton of ads. So, the company does have to strike a fine balance in terms of monetizing its audience, but also providing that incredible user experience. I think management has done an amazing job when it's come to that. I still have confidence that they will be able to do this in the future when it comes to monetizing WhatsApp and Messenger, which they gave a little bit of color on, and how their monetization for Messenger was a little bit slower than they expected it to be.
Lewis: There are other things that play into that revenue number. Ad load is one of the main factors. But the gains are also driven by active-user growth and advertiser demand. So, what we're seeing in other parts of the business is, MAUs and DAUs keep climbing. We saw that the ad rates that people are willing to pay for keep going up, too. So, even as ad load decreases, we may not see the same gaudy growth, but that's not to say that we're not going to see growth on the Facebook platform itself.
You hinted at some of the Messenger stuff. I think if you're looking at this business, that's really where growth could come in the next five years, because of the massive user bases with the WhatsApp and Messenger platforms.
Susarla: Exactly, there are over a billion people using Messenger and WhatsApp individually. Currently, the management has said they wanted to grow the user base instead of directly monetizing it, but I think they're coming at the point now where they slowly start wanting to introduce ads to a select few and see how the response is with that. I think investors are a little bit antsy, and depending on when they want to see that monetization, they want to receive the gains now. But I think Facebook is continuing to remain steady with its core mission and building its user base as much as possible, and then slowly starting to roll out ads and monetization.
Lewis: And if you read the call, you see that Mark Zuckerberg is also starting to get a little bit antsy about it, and wants to turn on the monetization engine there. They have a history of being very deliberate in monetizing all of their platforms, and really doing their best not to compromise user experience. I think the massive user-growth numbers that we see speak to that. As an investor, knowing that this is one of the next big runways for them, I'm pretty excited that CEO Mark Zuckerberg is on board and wants to make that happen, because that's really where the next phase of growth for them comes as a business, I think.
Susarla: Yeah. Facebook is really still in that investment phase. They talked about, in their earnings call, how they're continuing to hire more engineers, build more data centers, and really gear up for the future, and having a long-term vision that they want to execute on.
Lewis: So, much [as] with Alphabet, I also own Facebook, and my outlook is pretty rosy for them, too. I think you're definitely going to see some slowdown in the second half of the year. Management wouldn't be signposting it the way that they have unless it was going to be happening. I don't know what that's going to be. They don't offer revenue guidance, so it's a little tough. But even if it's down to the 30s, that's still pretty darn impressive for a business their size that has not turned on the switch for two of their huge platforms.
Susarla: Right. Facebook has a market cap of $500 billion, but it's growing ad revenue twice as fast as Google. So, that'll be really interesting to look out for.
Lewis: Yeah, two competitors to watch in the digital ad space.
Lott: Battle of the Titans, absolutely.
Susarla: Are they on a collision course? We'll see.
Lewis: We'll see. Thankfully you guys are not on a collision course, and it was a nice collaborative podcast. [laughs] Anything else before I let you guys go?
Susarla: Just two tech companies that are really amazing stories of our time. These are the companies you want to tell your grandkids you own. We'll see how they do in the future. But, positive outlook.
Lott: Aneesh, I completely agree with you. A pleasure to be on with you, Dylan, thanks so much!
Lewis: And thanks for all you guys did over the summer here at HQ.
Susarla: Yeah, definitely. A lot of key takeaways from the summer. I'm excited for the future.
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions for me or any of the other hosts, you can shoot them to firstname.lastname@example.org or tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can 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. Thanks to Dan Boyd for all his work behind the glass. For Aneesh and Connor, I'm Dylan. Thanks for listening and Fool on!