Should Investors Be Concerned About Alphabet's Recent Struggles?

By Markets Fool.com

Image source: Alphabet.

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Last year, Larry Page, then CEO of Google, announced the company's transition to Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL). On Alphabet's investor relations website, Page outlined the reasons for the transition: better accountability, independence, and focus. For investors, Alphabet would separate its core Google operations from its other independent companies, dubbed "other bets" when reporting company financials.

Recent reports from technology-focused websites point to continual struggles in Alphabet's other bets segments. The Information noted Google Fiber's chief, Craig Barratt, almost left post-transition because he was concerned the company's new structure would make it harder to attain assets. It appears those fears were prudent as the company has now been ordered to cut costs.

In an article aggregating Google Fiber's woes, a push for profitability that pushed Nest CEO Tony Fadell out, employee losses in its self-driving car project, the recent suspension of Alphabet's swappable-smartphone-components project, named Ara, and a rumored shakeup of the company's secretive lab X segment, Business Insider calls Larry Page's Alphabet transition a "mess." Investors should ignore the hyperbole and focus on the company's operations.

CFO Porat appears to be more focused on controlling expenses than predecessor Pichette

After taking the Alpahebt's CFO reins in May 2015 after leaving investment firm Morgan Stanley, Ruth Porat instituted a change of tone in regard to then-Google's "earlier stage" products and expenses. For a comparison, previous CFO Patrick Pichette discussed Google Fiber in terms of innovation and "pushing the envelope," and did not address expenses in a meaningful way in his last earnings conference call (the first quarter of 2015).

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Porat's second-quarter introduced the terms "tight governance" in regard to resources for Fiber, Life Sciences, and Nest. Additionally, Porat mentioned "discipline in expense management" as a reason for year-on-year expense-growth deceleration and a 1% sequential decrease in expenses. In the third quarter, Alphabet decided to return those savings, and then some, to investors by instituting a share buyback program in excess of $5 billion.

But R&D expenses show Alphabet is still investing

Assuming complaints coming from Alphabet's "other bets" segments are valid, it appears Alphabet is not cutting spending on investor-desired research and development.

Metric Q2 '16 Q1 '16 FY '15 Q3 '15 Q2 '15 Q1 '15 FY '14 Q3 '14
Revenue $21.5 $20.3 $75.0 $18.7 $17.7 $17.3 $66.0 $16.5
R&D $3.4 $3.4 $12.3 $3.2 $2.8 $2.8 $9.8 $2.7
R&D/revenue 15.6% 16.6% 16.4% 17.3% 15.7% 16% 14.9% 16.1%
R&D growth 20.6% 22.3% 24.9% 21.7%

Source: Alphabet 10-K and 10-Q statements. Revenue and R&D figures in billions.FY = fiscal year.

As the table above shows, Alphabet is not cutting spending on research and development. With the exception of the recently reported second quarter, Alphabet has grown its research and development as a percentage of revenue every quarter Porat has been CFO on a year-on-year basis. In fiscal year 2015, the firm increased this statistic 1.7 percentage points.

On a raw-dollar basis, the growth is even more apparent. After taking over in earnest in the second quarter of 2015, research and development spending has increased at least 20% on a year-on-year basis with Porat at the helm. What appears to be occurring is a shift in research and development spend to profitable assets or asking for Alphabet managers to cut spending on non-R&D costs like sales, marketing, general, and administrative functions.

Ask yourself why you purchased Alphabet

For investors, itcomes down to a question of why you chose to invest in Google or Alphabet. Presumably, most investors purchased the company for its core search and display advertising business. If so, you should appreciate the new austerity measures in these nonessential divisions and the company's recently announced share buyback program. This puts investors at odds with most technology-focused websites, as the news outlets' circulation is better served by new products, even if these products are unprofitable.

In the event you purchased Alphabet in the hope it'd become a technology version of Warren Buffett's Berkshire Hathaway, and you are betting one of its moonshots becomes the next must-have technology, you may want to reconsider your initial thesis in light of reports about Alphabet's talent departures and capital-allocation policies.

More disciplined spending should show up in future periods

Alphabet's other bets were always interesting to discuss, but are not a large part of the company's revenue haul. In the first six months of 2016, even after registering 130% growth, Alphabet's other bets were less than 1% of the company's total revenue. It makes sense for the company to keep a tight rein on expenses here until a path to revenue is reasonably assured.

Throughout the first six months of the year, other bets reported $350 million in revenue, but the segment reported $1.6 billion in operating losses. Alphabet's operating income would have been 10% higher if this segment did not exist. If the reports are correct, Alphabet's keeping expenses under control coupled with its share buybacks should increase earnings per share and drive the stock higher.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fools board of directors. Jamal Carnette owns shares of Alphabet (C shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Berkshire Hathaway (B shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.