Alphabet Makes Its Own Rules; and the Big Deal That Wasn't

Tune in for breakdowns on how we're even more confident in Spotify's (SPOT 2.77%) ad strategy after pouring through the results, and how Alphabet's (GOOG -1.96%) (GOOGL -1.97%) Google's properties continue to defy the law of large numbers. Also, we touch on the Pinterest (PINS -0.64%)/PayPal Holdings (PYPL -1.14%) deal that wasn't.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 28, 2021.

Dylan Lewis: It is Friday, October 28th, and we're talking tech earnings and the Pinterest deal that wasn't. I'm Your host, Dylan Lewis and I'm joined by Fool.com's elated earner of extra extreme extravagance, Brian Feroldi. I almost got through it.

Brian Feroldi: Yes. Yes, I did it again. I got Dylan again.

Lewis: It's a tough one.

Feroldi: It must be because we are recording a day early and you are not in your game face. [laughs]

Lewis: I'm off my game. We were out of the member livestream. Perhaps I didn't have my best talking head on, Brian. Maybe that's what it is. I will say the EX is hard. It's a tough one, it will trip you up.

Feroldi: You shouldn't have said that because now every title moving forward is going to have EX's in them. [laughs]

Lewis: I like the tongue twister though and I like the challenge. If we're not being challenged, we're not getting better.

Feroldi: That's right.

Lewis: [laughs] We're talking tech earnings today. There's really no shortage of interesting results from companies we talk about. Brian, we're also going to follow up on the Pinterest-PayPal deal that we talked about last week and basically put that show in the can on Friday. I think we woke up to the news cycle on Monday and basically said that deal's not happening, we're going to get into some of the details there. But first, I figured we would talk about Spotify and we're going to talk about Alphabet as well and the earnings they released. Spotify, a company that's near and dear to my heart. It is near and dear because it's in my portfolio, something that I bought recently in 2021. I'll just say, pretty awesome quarter for this business. I looked at all the top-line numbers, looked at the financials, everything came up roses for me. Strong user growth for this business. We're even seeing average revenue per user start to turn around, which is an improvement. A lot of good stuff in this report.

Feroldi: The numbers that Spotify just put up are bonkers. 381 million monthly active users, that figure was up 19% year over year. What's truly impressive to me though, about this company is its conversion rate into paying subscribers. Spotify has 172 million paying subscribers. That's a conversion rate of 45%. Normally with a business like this that employs a freemium model, I would expect to say if they got 5% of them to convert, that would be an impressive number. That is something that has always stood out to me about Spotify.

Lewis: It's impressive and I think what's interesting about this business is I don't know that I have a huge preference when it comes to people being paying subscribers or ad-supported members, or listeners just because of where this business is going with its financials. For a long time the narrative was average revenue per user is declining. They're focused so much more on long-term value of the people using the platform, feeling like they want to get people in and they are willing to accept lower prices to start. But what we've seen recently is this huge focus on the ad-supported part of their business. Really bringing advertisers in, creating a solid revenue base and exploring what they're able to do with data, and serving up relevant ads to that free audience. Some of that has been in the podcast side where even paid listeners are getting ads. But I think Brian, as they mature that business and they turn into something that's a little bit more interesting, the free user base that they have actually is a massive opportunity for that.

Feroldi: It certainly is. To dig into those numbers some more, total revenue for the quarter was up 27% to $2.9 billion that was ahead of Wall Street's estimate by about 100 million. But if you double-click into that number, we're seeing a similar story and different growth rates, albeit. The premium members, they generated $2.2 billion of that $2.9 billion in total revenue, that figure was up 22%. But the ad-supported revenue was $320 million. Still not a huge number when compared to the top line, but growing at an outstanding rate, up 75 percent. It clearly shows that their focus on that ad-supported revenue is working. That's a huge part of the thesis for me with this company. I think one of the things that I struggled with for a long time looking at this business was people love the product. It's a pretty awesome value when you really think about it. To be able to listen to almost anything you want, download it, have it on your phone for 10 to 15 bucks a month depending on what plan you're on, you'd spend so much more than that in the conventional CD model when it came to listening to music. It's an incredible value-add. But it's not really a financial model or business model that the company has all that much control over because they have to pay those royalties out. You'd love to see them establish their base of revenue that scales and that they are able to enjoy operating leverage on. It's not they're paying a fixed percentage of that for every dollar that's coming in out to royalties. That ad revenue gives them that opportunity.

Feroldi: Yeah. The company had its gross margin actually expand during the quarter, which was nice to see, by two full percentage point, and that two full percentage points really matters because, to your point, this is a fairly low-margin business. In the most recent quarter, that gross margin came in at 26.7%. Given the fees that they have to pay to access that premium music content, I think it is fair to say that any gross margin expansion from here is going to have to come from the ad-supported side of the business. It's nice to see that that thesis is working.

Lewis: We got a little color on the dynamics there from management during the conference call. They said free music margins are below premium music margins. I think if they are going to be able to add incremental advertising revenue, not just in their podcasting business but also bring any wins they have over there onto the free side with better targeting, that's going to help margins. I think for the most part we're seeing that the premium business is the driver of margins and it's going to dictate things right now, but it's upside that they have control over, which gets me really excited. Everything I hear from management is the roadmap for the ad-supported revenue just continues to check off milestones and keep working toward what they want to be doing. They said that segment meaningfully outperformed, driven by higher sold impressions, increased CPMs, and accelerated demand within their advertiser network. This is broad-based strength, particularly in the U.S. and United Kingdom, which you love to see because those are the two most important ad markets, North America and Europe.

Feroldi: Great to see. The other thing that's worth noting here is that while they are still spending like crazy, they are starting to produce operating income $14 million for the quarter, which was the second time in a row. When combined with the strong growth of the company and the fact that it's become profitable, at least on the operating level, that is a bull case for investors.

Lewis: Yeah, it's something to be excited about, [laughs] which I certainly am and it's why it's in my portfolio. I think we're still very much in the early earnings when it comes to this ad-supported revenue. Management, in their conference call, pointed out linear radio still has about half of the share of audio listening in the United States. More than 60% of all audio ad spending is going to go to traditional radio. Brian, if you think about that ad spend and the level of targeting you're able to do there, you don't have nearly the level of granularity that you would with a digital platform like Spotify.

Feroldi: To say nothing of the fact that when you are listening to an ad on your phone, the producer can actually also put links in there that can actually take you to the page to make a purchase. That's not something that you can do if you're listening to traditional linear radio. There is a lag, just like we saw with print. Money that was spent on print advertising slowly moved online. We're seeing that same dynamic in the listening market. I'm sure that five years from now, 10 years from now, almost all of the money in this market is going to be going into podcasting.

Lewis: Yeah. The ad-supported model continues to look strong. It's in the double-digit percentage now as an overall composition of revenue for the business. Management said they at least think that this will be 20% of revenue, could be 30% or 40% in the next five to 10 years. They see this dramatically increasing over time. I think that's going to play into margins over time as well. The tough part with these ad-based businesses, Brian, is you have to go through a little bit of an ugly period with scale. You have to [laughs] eat a lot of costs and some of that's going to be salespeople and some of it is just going to be the platform, building this network that connects advertisers and inventory.

Feroldi: Well, that's a long-term payoff that Spotify is willing to make and I think that that is the right thing to do for the business over time. That's just something that we see a lot of companies have to do. They have to take short-term pain in order to deliver long-term returns. But if you're an investor, you should be rooting that on.

Lewis: Yeah, definitely. I think what's cool is you can really track how all these pieces move together for this business. They emphasize podcasting and they have that free music listener base that is going to be served up ads. But podcasting is a huge piece of the ad inventory pie for them, and they call out. Three years ago, their catalog had under 200,000 podcasts and they were I would say a rounding error for a lot of people in how they counted the industry. Today, Brian, over 3 million podcasts on the platform. They very quickly moved from being someone who is thought of as a music streamer to really one of the dominant, if not the dominant, players in podcasting.

Feroldi: I can just speak for myself and say I resisted downloading Spotify for years simply because I've used Apple's podcasting app gleefully since I started listening to podcasts over a decade ago at this point. Just within the last few months, I actually did switch over to using Spotify specifically because there were some podcasts that I could no longer access on Apple's network. So Spotify got me as a customer.

Lewis: Yes, I think they were able to nudge people with the exclusivity, bringing some shows over and saying you got to listen to them in Spotify skin. I also think that this might be a story of someone being smaller and more focused versus a much larger business that has a lot going on and more to manage. Maybe that offering isn't as in focus for company management and it's not as much of a priority. You're able to be so much faster, so much more nimble when you have a single goal. Sometimes that can look like you are a small fish going up against a big fish. But it also means that you can probably bring things to users a little bit faster than Apple might.

Feroldi: There is benefits to having hyper-focus on one thing, even if that one thing just looks like a feature on somebody else's product.

Lewis: Yes. I think looking forward, I'm excited about this business because of so much of what we just talked about with the dynamics of the ad business, the strength of their core subscription model, of course, as well. If you look at the company guidance, though, Brian, they put out a big number that I think is really just a "this business is not going anywhere" type number, and it's that they're targeting 400 million monthly active users by the end of the year. That where they see this going. I think there have been concerns about this company for a while and the competitive pressure from the likes of Apple. Just wondering, can something that is a feature in someone else's ecosystem really be a stand-alone business? I think at 400 million monthly active users, they've reached the critical mass of scale that you can safely put that one on the side.

Feroldi: For sure. Even the more exciting thing about that is if you compare that 400 million potential users to the number of smartphone users that there are globally which has measured in the billions, even from that huge number, there's still upside.

Lewis: We, I think, tend to overstate the impact and reach of Apple's ecosystem being in North America. The prevalence of the iOS platform is huge in North America, but if you go to other parts of the world and if you look at the breakdown of users for Spotify, North America is a very large part of it, but it is a piece of the pie and for the most part, you're looking internationally for folks and most of their users. You're going to find that there're a lot more Android users internationally and that's a huge opportunity for Spotify. The ARPU might be lower for some of those folks, but if you're thinking about acquisition and long-term growth of the platform, that's a massive opportunity and a place where they have a lot less competition from Apple.

Feroldi: Certainly is. The international opportunity remains massive for the company. I mean, I can just speak for myself. I still have friends to this day that I ask if they still listen to podcasts and they say no because they don't know how to listen to podcasts. It's like, you ever click that button at your phone that says podcast? It's worth checking out. So yes, podcasts, while they have gone mainstream, I'm confident that there's still a whole lot of potential users out there that haven't even discovered the medium yet.

Lewis: You know what, that also means that there are a lot of potential Industry Focus listeners out there that have not yet discovered the medium. It's like, come on, man. I do this thing once a week. Just tune in. [laughs] Brian, we can't talk ads without also talking Alphabet. Some pretty killer earnings from them. I think this is a business that if you haven't been closely paying attention to, you forget how impressive the numbers are coming out of it.

Feroldi: Google's numbers are just unbelievable. There's no real other word for them. At the size and scale this company is operating at, the fact that it just grew its revenue by 41% during the quarter is outstanding. This company just put up $65 billion in quarterly revenue. That beat Wall Street's estimate by almost $2 billion. How many companies can you say had a $2 billion quarterly revenue beat? Just outstanding. What's equally exciting is the rest of the income statement looked fantastic as well. Gross margin was up 330 basis points during the quarter to 57.6%. There is some accounting wonkiness that helped to drive that number, which we'll get into a little bit, but still very impressive. Meanwhile, while the company still continues to spend like crazy, expenses only grew 26% during the quarter. That was much slower than revenue. As a result, operating income grew 80% to $21 billion. Net income grew 69% to $18.9 billion, and thanks to some stock buybacks, which actually reduced the share count, earnings per share grew 71% to almost $28, beating the estimate by $4.75. Wow.

Lewis: [laughs] Those numbers are outrageous. I mean, they really are. For a nearly $2 trillion business to be putting up 40% top-line growth and 70% net income growth, I don't know that we've ever in human history seen businesses this big grow this fast.

Feroldi: Absolutely not. What's equally exciting is you dig into really any of their core properties and they're all growing very quickly. Search, up 44%, Google's Network's up 40%, Google services up 41%, Google Cloud up 45%, YouTube up 43%. An interesting tidbit about YouTube, YouTube's quarterly revenue was $7.2 billion. That figure, again, was up 40% year-over-year. That is knocking on the door of where Netflix is. Netflix during the most recent quarter, did total revenue of $7.5 billion, and Netflix is only growing 16% per year. YouTube growing 40% per year. YouTube is quickly approaching becoming the new king of streaming.

Lewis: It's really incredible and I think you can lose sight in some of these larger businesses just how impressive some of these "smaller" segments, $7 billion, segment YouTube is and really what they would look like as a stand-alone company.

Feroldi: Yes. If you annualize that number and do, what was that, 29 roughly billion dollars in revenue? I mean, what kind of price-to-sales multiple with a business like that fetch? At least 10, maybe even 20 in today's market. So YouTube itself could be a $300, $400, $500 billion business on its own.

Lewis: Yes. It's just one prong of this incredibly attractive business. We have YouTube and we have just all of the natural search interest that Google is able to garner with its core search properties and then, by the way, yes, we have cloud business as well, Brian.

Feroldi: That cloud business is rapidly growing. It is one of the big three cloud businesses. Importantly, it is still losing money. Google is trying to scale it so rapidly that it's producing operating losses. During the quarter Google cloud business resulted in a $644 million net loss. That was actually cut in half from the year-ago period, so the business is reaching scale rapidly and it should start producing operating cash flow soon, but still, given the growth and the opportunity ahead for Cloud, we want the company to be making those kind of investments.

Lewis: Yes. They're coming into that spot perhaps in a tough position in some ways because we've gotten so used to cloud segments being this incredible operating segment that lifts up the financials of these big tech companies. I mean, AWS went from "what is that?" to the whole thesis for Amazon very quickly. I think Microsoft's similar where we see it as this cash cow type business. Coming in a little bit later in the game and having to steal market share rather than possess that market share, it puts you in a tougher spot as a competitor.

Feroldi: Yes, but Google does not need that business to drive any financial results because it has a cash printing machine that is search. It could continue to fund that like crazy, which I think is the right move. Now, one thing that's worth noting in the company's 2021 results was that they changed the way that they calculate the depreciation on some of their networking equipment. Previously, they were depreciating that network equipment over a three-year period. They decided to change that to over a five-year period. As a result, their depreciation expense has gone down, which has the effect of making their net income look a little bit higher. So that is one wonky accounting change that is pushing their near-term margins up. Still, even if you remove that effect, the numbers were just very impressive across the board.

Lewis: Yes. I'm not too concerned about something like that. [laughs] I think if there is ever an area to scrutinize this company, it's the other bets segment, Brian. I know over the years, it's gone from this fantastical factory that people think, there's this upside, you have this venture arm of this business looking for moonshot-type projects, 10X type opportunities. We've seen some interesting stuff there, but I think generally the narrative has been this is a financial drain for this business.

Feroldi: Yeah. It still is. The company did report a $182 million in revenue for the quarter. That figure was only up 2% over the year-ago period, but it is a financial drain. The operating income from that second segment was negative $1.3 billion. As of yet, growth investors are still waiting for something to come out of there that really shows that those investments are going to pay off. We still have some waiting to do.

Lewis: Yeah. I think if there is a recognizable name from that "other bets" segment or some of those more futuristic investments, it's the Waymo segment, that mobility segment, the driverless cars segment. We see a lot of headlines and I think over the last couple of years we've seen a lot of headlines about Waymo. We keep getting those inch forwards in progress. But perhaps not the self-driving headlines with the likes of Tesla get as regularly.

Feroldi: Yeah. They did call out that Waymo is testing a rider programs in San Francisco that's in addition to its fully autonomous ride-hailing business that is currently operating in Phoenix. Next year, they're going to be doing a dedicated tracking hub in the Dallas, Fort Worth area to help them get into the freight business. Waymo still does have massive potential long-term, but they are going up against the likes of Tesla, which has, in theory, a massive advantage on the data side of things. Yes to your point, I love this company, that it's made all those investments in those other bets and it continues to be willing to pour money into them. At this point, I would've liked to see one payoff, but on the flipside, YouTube alone has been a grand slam home run of unbelievable proportion. If you're a Google shareholder, you can't be anything but happy.

Lewis: Yeah. I don't think you can fault their capital allocation too much. With the sheer amount of income that they're producing, they have to take some investment bets and just look for things that have some really large upside. For a business that in a single quarter puts up [laughs] $65 billion, you need something that's substantial in order for it to really move the needle. There have to be some big, hairy goals. A lot of those aren't going to pan out. But you hope that there is some lottery ticket-type business in there somewhere.

Feroldi: There likely is to be and management did call out in the call that they are currently making big investments in Africa to get to more consumers online. They're making investments in AI, they are building out their own metaverse. Google has plenty of things in the hopper that could pay off over the next couple of years. But in the near term, the next couple of years, the results are going to be driven by YouTube and search.

Lewis: Brian, I think the natural question, when you see a business that's worth $2 trillion as companies get bigger and bigger is, is it too big to put up meaningful returns? I think a lot of Alphabet shareholders are probably pretty delighted over the last year because this was a company for a little while, it was up into the right. It was rewarding shareholders, perhaps not as aggressively as some of its big tech counterparts. But over the past year, almost sitting on a double for a business its size. I look at it, $2 trillion business growing 40% year over year. This one is happily staying in my portfolio. I have no intentions of selling it anytime soon. I'm curious though what your take is.

Feroldi: Ditto for me, too. I always look for the companies there's growth rates and as long as they're putting up double-digit revenue growth, that's what I really expect from these companies. If you look at Alphabet, not only is it expected to put up 39% total growth this year, Wall Street is estimated that this company is going to put up 17% revenue growth next year. As big as this company is, as huge as it's become, as great as it's done long term, I still think there's reasons to believe in this company is going to do just fine for its shareholders.

Lewis: Yeah. One of several companies that have just continued to defy the law of large numbers. I think if you'd bought a portfolio of Alphabet, Apple, Microsoft, and Amazon, and just forgot about it for a little while, you're probably feeling pretty good. I think that's probably the case going forward too, Brian.

Feroldi: Yeah. Google is very much in my never-sell portion of my portfolio. I've actually owned Google stocks for going on 12 years now. Hope to make it another 12, that'd be great.

Lewis: [laughs] Before we wrap Brian, want to touch on two companies that we also both own, PayPal and Pinterest. Last week we were talking about a proposed deal. There were rumors that PayPal would be buying Pinterest. We have an update on that and it seems like that deal is not happening.

Feroldi: Yeah. We noted in the show that normally when rumors of that scale are flooded out there, they usually are more often than not, are correct. This would appear to be one of those cases when it was not correct. PayPal did put out a press release earlier this week saying, "In response to market rumors regarding a potential acquisition of Pinterest by PayPal, PayPal stated that it is not pursuing an acquisition of Pinterest at this time." When that news did hit the wire, PayPal stock went up a little bit. Pinterest stock got whacked. The reported take-out price of the rumor was somewhere around $70 per share. Last week, Pinterest was trading in the low $60s in response to that, today it's trading in the mid-$40s. Investors were really disappointed to see that this deal didn't go through.

Lewis: Yeah. I think it makes sense. There are probably a good number of folks after the tremendous ride that the company had been on for the last year and a half or so that have been a little frustrated with where it's been for the last six to eight months. I'm certainly one of those people who has a position that's sitting in the red. I will say as a Pinterest shareholder, I'm happy that this deal didn't go through. Also as a PayPal shareholder, I'm happy that this deal didn't go through. I think there's upside here for Pinterest. I did have some doubts about strategically how it fits into PayPal. I don't look at this as a failure in any sense. I think it's two quality businesses. They don't always necessarily make one quality business when put together.

Feroldi: Yeah. I think that's fair. Pinterest at the current prices is only a $30 billion company. I say only because I continue to believe that its platform is very monetizable, especially when compared to some of the other social media platforms that are out there. Again, for a sense of scale, Facebook, even though it's come under a lot of pressure, stock price is under a lot of pressure recently, that is almost a $900 billion company. The question I ask myself as a Pinterest shareholder is, is there room between Pinterest's $30 billion market cap and Facebook's $900 billion market cap for Pinterest to continue to grow? I still think the answer is yes.

Lewis: Yeah. I think if you wanted to aim a little lower, but still show what that upside it looks like Snap is almost a $90 billion company, which is a 3X from where Pinterest is. Still pretty early on in the monetization efforts there. They've been able to enjoy a lot of success with the switchover to programmatic, but I think there are a lot of similarities, where this is a business that has a really dedicated and interested user base. One that is not growing or nearly at the scale of the likes of Facebook, has still proven to create a pretty solid business and put up some really awesome returns for people that bought in a little bit earlier.

Feroldi: Yeah. Like you, it was noteworthy that the company wasn't going through with the acquisition, but when I find a company that checks a lot of boxes for me, I hate it when they get acquired, especially after they've only been public for a little while. I'm going to continue to be a shareholder of Pinterest, although I do recognize that the next quarter or two might be a little rough.

Lewis: Yeah. It could be that there's more pain ahead, and I'll go back to that Snap parallel. That was a business that we dogged on the show and we talked about the struggles that they had and some of the more sensational elements of the business that came public and some of the corporate governance issues. It was in the doldrums for quite some time. I think a lot of people who bought shortly after it came public were in the red for almost two years and before it went on to provide multi-bagger returns for a lot of people. There's upside there and I think focus on the ARPU, focus on the monetization efforts, and you're probably pretty happy. I think Brian, it's a helpful reminder of why we are long-term investors here at the Fool. I remember in a previous job, we had a merger arbitrage segment that was basically people that were focused on identifying opportunities in mergers and acquisitions. My boss said to me, I got to be honest, I don't really know why we do this. It feels like picking up pennies in front of a steam roller.[laughs] I think it's a very good way to describe any short-term movements that you're trying to make related to companies being bought or not bought.

Feroldi: Yeah. If you were trying to buy Pinterest last week in the low $60s with the hopes of a deal would be coming through in the $70s thinking there's an arbitrage opportunity here. If that was your entire thesis, boy did that get blasted apart with one press release.

Lewis: Yeah. For PayPal, there was clearly some pessimism around the deal. Look, quickly rebounded immediately after this news broke that it was not happening. That's why we're business-focused. That's why our thesis is based on where this business is going over the next couple of years, hopefully decades. Just a reminder, don't over-index to the news too much.

Feroldi: I saw a great quote recently by Tom Gayner, the chief investment officer at Markel. He says, "I'm a long-term investor because I don't know how to be a short-term investor." [laughs]

Lewis: I think that's right. It's too much work. It's the lazy way of doing things and I'm happy to be lazy in that sense.

Feroldi: I'm right there with you, Dylan.

Lewis: Brian. Thanks as always for joining me.

Feroldi: Have a great weekend, Dylan.

Lewis: You too, man. Listeners, that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach and say, hey, shoot us an email, [email protected], or tweet us at MF Industry Focus. If you're looking for more of our stuff, subscribe on iTunes or wherever you get your 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. Don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for all his work behind us today, and thank you for listening. Until next time, Fool on.