The full force of the U.S. Federal Reserve's aggressive interest rate hikes is starting to be felt during third-quarter 2022 earnings. Even mighty Alphabet (GOOGL -1.39%) (GOOG -1.29%) and its main Google Search moneymaker is feeling the hurt. Year-over-year revenue growth slowed to a 6% trickle in Q3 and totaled $69.1 billion.
But just how much of a drain was the Fed's actions on Alphabet's earnings? Let's break it down.
King Dollar's harsh rule over operating profits
The Fed's record increase in interest rates this year has had a nasty side effect: a record run-up in the value of the U.S. dollar. As a refresher, when the dollar increases in value versus other currencies, that lowers the value of international revenue for a company that's based in the U.S. Google is very much an international company, so the dollar's strength has taken a big bite out of reported growth. Backing out exchange rates, top-line revenue increased 11% year over year in Q3.
But there's an even bigger toll King Dollar takes. As explained by Alphabet CFO Ruth Porat, most of the company's expenses -- especially research and development expenses (which were 15% of revenue versus 11.8% of revenue in Q3 2021) -- are made in dollars. When revenue is collected in a weakening foreign currency, converted to dollars, and then spent in dollars, that has an outsized effect on operating income. Paired with a general rise in employee headcount that outpaced revenue growth, the dollar's impact on operating profit margins was severe: 25% margin versus 32% last year.
Other interest rate issues and Google's spending spree
Wait, it gets worse! As the Fed sharply raised interest rates, the value of investment assets decreased. Such is how the internal mechanism for valuing investments (assets with expected future cash flows) works. And Alphabet owns a lot of investment assets. As of the end of September, it owned $94.3 billion in short-term marketable securities and $30.4 billion in long-term non-marketable securities.
Alphabet revealed the reduction in the value of these investments due to rising interest rates: $1.38 billion. That compares to a $2.16 billion gain reported in Q3 2021. Year over year, that's a $3.54 billion quarterly swing affecting net income and earnings per share.
But let's not levy blame solely on the Fed. Alphabet has also been spending heavily on property and equipment in recent years (mostly data centers and related hardware). Property and equipment were valued at $108 billion on Alphabet's balance sheet at the end of September, compared to $97.6 billion last year. While this equipment is generally purchased upfront but then expensed over time for tax purposes, this led to an increase in depreciation last quarter. Depreciation is a non-cash line item, but it nonetheless decreases net income and earnings. Depreciation was $3.9 billion, compared to $3.1 billion last year.
Finally, there's stock-based compensation. Stock-based comp paid to employees was nearly $5.0 billion, compared to $3.87 billion last year, another effect of a rising employee headcount.
These small moving parts add up to one big headwind for Alphabet. All told, a 6% reported revenue increase equated to a 26% decrease in net income or a 24% decrease in earnings per share when factoring for the $15 billion worth of stock Alphabet repurchased in Q3. Most, but not all, of this is thanks to the vicious rise of the U.S. dollar.
Time to panic?
The good news is that once the dollar stops its rise (perhaps around the time the Fed slows or stops raising rates), this drag on Alphabet's revenue and profitability will also stop. And if other currencies start to catch up with the dollar again, it would be a benefit for Alphabet's reported revenue and earnings. In the meantime, Alphabet will help itself with a planned slowdown in hiring to close out 2022 and into 2023.
Alphabet is still a growth stock, and even in a far-less-than-perfect quarter, it's highly profitable. Shares trade for 19 times trailing-12-month earnings. I'm still a buyer as the market severely punishes this stock on short-term headwinds and fixable problems.
