Paypal and Alphabet Spell it Out for Investors

By Sarah Priestley and Dylan Lewis Markets Fool.com

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

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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.

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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'sFriday, Jan. 27, and we're breaking themquarterly results fromPayPalandAlphabet. I'm your host, Dylan Lewis,and I'm joined in the studio by fool.comtech 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: Areyou excited for pizza day?

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

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

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

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

Priestley:That'sprobably a good idea, yeah.

Lewis: So,Sarah, a ton going on in techthis week, the next couple weeks with earnings. Two pretty followed Foolcompanies reported yesterday after the bell. We dug into the reports andare ready to talk about them. You didsome of the heavy lifting with PayPal; I dug into Alphabet. Why don't wetalk 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 littlehigher than expected at 21%. Transactions were $1.8 billion. But the volume wasbelow 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 overreactionwhen 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 aremeasured on engagement, sonumber 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:Theoperating margin for the fourth quarter was down to 15.4%. The reason that we'recommenting on this is that that's a lot,it takes up a lot of roomin the bullish theses,that the new partnerships they've started witha 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'thave 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'sthe same thing forSquareand other payment processors; it's a standard transaction amount on card processing. So, that15.4% 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, DanSchulman,has said that they won't be a slave to quarter-to-quarter margin performance.

Lewis: Which issomething we like to hear as Foolish investors.

Priestley:That'svery true. And,I would also comment thatthe management team is reallybeing driven for their compensation package on thelong-term performance of this stock,and I think that really shows in their reporting. They'refocused on free cash flow in theirprojects, 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 yearincreased 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, theirfiscal Q4 comeswith the calendar Q4, sowe 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, theactual processed amount was $99.3 billion, which missed the expectations. Interestingly, the majority of this was pushed by international. Internationalexpanded 27%. The U.S. was 23%.

Lewis: Andfor theunacquainted, total payment volume is justthe gross amount that they arehelping to facilitate.

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

Lewis: So, for the amount per transaction to be down, theymust be doing more total transactionsto be making it up in volumeand 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 quarterof 2017 orfurther out, broadly in 2017?

Priestley:Absolutely. I'll look for 2017quarter four revenue we're expecting to growon a currency neutral basis16% to 18%. That gives you a range of $2.9 billion to $2.95 billion. That wasactuallyslightly more conservative thansome analysts were expecting, which played into their share priceperformance 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 thereanything to worry about withsome of these numbers that we're looking at, thatmanagement growth projections are different thanwhat 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 conservativein 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'reworking on now, Venmo has increased 100% year over year. It wasTime Magazine'sbest app, it's processed $5.6 billion, which was up 126%. So,I think they have ahuge potential with a lot of the projects they're working on; they'veexperienced huge growth. The problem with these is that they are not monetized yet. And ananalyst actually raised the question in the earnings call: "Is yourprojection in 2017 building insome of the expectations formonetizing this, and also Xoom?" which is their international money transfer program. They dismissed this. They saidit was pushing out to 2018, some of theopportunities,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 seethe fruits of that labor.

Lewis: Yeah, and you said, 55% ofwhat was being processed, broadly for the business, wascoming from mobile. When you look at Venmo specifically,that is almost entirely mobile. It's more peer-to-peer. There aresome 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 becauseyou bought me lunch the other day, they don't really take anything on that.

Priestley:No,they don't. Andsomething to say is,it's becoming a hugely crowded market. I thinkPayPal, to some degree, has a first-mover advantage, but they'redefinitely not the biggest player in this industry. The banks have gotten together and created clearXchange, which is a peer-to-peerpayment which is also free right now. It'sowned 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 ishugely 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 that75% ofswiping transactions were from Apple Pay.

Lewis: Wow. It'shard 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 haveBank of Americamobile payment processing?" So, they do seem to have that first-moveradvantage, 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 aregoing to have to be patient on that, ifmanagement 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 Touchbasically enables youto fill in your bank details, and you work through PayPal,and you can just click one button at the checkout and it's transacted throughPayPal, 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 tothe 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 a74% cart-abandonment rate on mobile.

Lewis: So whenpeople reach that checkout phase and theysee 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 hada 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 hugepotential 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 thatmanagement provided color on with the business, andstrategically where they're looking, thatinvestors should know?

Priestley:I think the focus is absolutely on mobile. Dan Schulman hasdefinitely commented on the fact that mobile is the biggestopportunity for them, and there are a lot of industry tailwinds that they're experiencing right now. AndI would completely agree. I thinkBlack Friday this year was the biggest online shopping day in history. Inquarter three last year -- we're still waiting for quarter four --the Census Bureau said thatonline 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'vetalked a little bit in the past aboutcontinuing to be an asset-light business. Is that something that management recommitted to inthe 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 Schulmancommented that it's a really competitive environment for this. I think the payment space isjust getting more and more competitive, every angle of it. Butoverall, I think this is definitely a good movefor the company. It's the right decision,it's going to eliminate some risk. Butit's also potentially going to bring in a degree ofrevenue 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'smobile initiatives. The core businessseems 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 onsome of their partners. They've had some really high-profilepartnerships withAlibaba, Vodafonein the U.K. and Europe, and many others; Discover, that they recentlyannounced. 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 theirexpectations. So,yeah, I agree with what you said. I thinkmobile is going to be a big area of focus, we'll continue to have a look at those transaction volumes and customer engagement.

Lewis:SoSarah,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'sreally 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, Alphabetreported the same time, yesterday after the bell. What were the results?

Lewis: Overall, Alphabet'srevenue 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 theimmediate 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,MarketWatchwriter Jeremy Owen doesa really good job breaking down the specifics, butthe gist of the issue is,the Financial Accounting Standards Board issued some changes a while back,basically impactinghow companies can treat stock-based compensation for their adjusted earnings numbers. And that wound up impacting results for this quarter. Moving forward, the company willno 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'sreally unusual, the change for GAAP there.

Lewis: Yeah. Typically, you think of non-GAAP numbers as beingsomething where the Financial Accounting Standards Board gives people adecent amount of latitude to operate how they want to. Butthey 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 GAAPnumbers, especially in the tech space. Looking ata couple of the different segments, their Googlesegment, 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 isgenerally performing pretty well. Their Google Sites segment, which is themajority of that, was up 20% year over year. Network revenue up 7% year over year. Other revenue, which is a smaller portiona little bit less related to the internet properties within that segment -- thinkHardware, 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 withinSundar 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 thenumber 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 isnot really a surprise. This is a story that's beenplaying out for a long time. Wetalked about the shift to mobile when we weretalking about PayPal. The same thing is happening with internet search. CPCs have been driven downbecause the effectiveness ofmobile 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'sactually quite a parallel there withwhat happened with PayPal and thevolume making up for the smaller transactions. We'reseeing the same effects here with Alphabet.

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

Lewis: I think it's something that, atthis point, we shouldn't be too surprised by. This story has been playing out for a decent amount of time. If it reallyaccelerates, you might have to worry. But they have been very good atmaking 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 thattransition to mobile,I think we're going to continue to see this for a while, unfortunately.

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

Lewis: Yeah, this issomething that people love to ask about, because it's like, "Where isGoogle wasting all of this money?" As a reminder, this is basically all the stuff they do that isn't tied to theirinternet properties. Think of it as their moonshot projects. The big financial contributors for this segment are Nest, Fiber, and Verily. They tend tofocus on a full-year breakoutfor the segmentbecause the numbers are so smallrelative to the overall business. But revenue came in at $809 million for 2016, which was up82% year over year. Operating lossnot including stock-based compensation was $2.9 billion, down slightly year over year. But, thissegment is still a money pit for Alphabet, and I think it willcontinue to be. They have reined in costsa little bit under CFO Ruth Porat. I think she has forced all of the Other Betsinitiatives toat least be able to show a path to monetization, or a road map towhat that might look like. But I think there's a certain test-and-innovateatmosphere that they want to maintain. Andinvestors have been OK with that, because their core internet business just prints money for them.

Something that isinteresting with them and the Other Bets segment is, they spun outWaymo, which is their autonomous drivingsegment. 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." Andwe didn't get any financial insight into what's going on with that. But they talked about it in the call. Ruth Poratprovided some commentary on what they'rebasically 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 Italked about in a podcast when they announced that a few months ago. As we, in the next couple quarters, overthe next year, continue to get more information about Waymo,I think we can look at that specific business segment and see the path forwhat's going to be going on for some of the Other Bets as theycontinue to mature and eventually see monetization. So, not a ton to report with Other Bets stuff, butat least we have something that we can start to track for what the company's ambitions might be.

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

Lewis:I thinksome of the things that people need to keep in mindwith this report,because the stock was down after hours, I thinkas of taping this morning, they were down 40 or 50 basis points,so not a crazy reaction like 3% that we sawafter 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'straded up for a while. I think it's somewhere in the teens in the last year or so. So, there's that. Andalso, Alphabet does not provide detailedquarterly guidance. Mostcompanies do offer up that guidance, and analysts create their ownmodels based on those numbers, those line items, and they have theirputs and takes totweak it slightly. But because Alphabet doesn't givethose baseline expectations, thelikelihood of actual numbers beingdifferent than analysts expectations isslightly higher than it would befor other companies. So, the market's reactionis always, I think, generally going to bea little bit sharper than what we might seefor a company that does offer standard guidance.

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

Lewis: Yeah. They havethe general trend of thingsand what they can glean from commentary. Butvery often, you'll seeanalysts' expectations more or less mirror guidance withslight adjustments. Not having that as a crutchcan 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 thenumbers, something that caught my eye that I think is a great point, andreally underscores the importanceof reading company conference calls, andnot just relying on the numbers that you see reportedand the quick earnings takes you'll see online: Mark Mahaney fromRBC Capital Marketsin the Q&Asection of the call asked thisreally great question, and I think it points to a looming risk forAlphabet, and I just want to highlight that for listeners. He said, "Itlooks to me like Google devices are being outsold 10 to 1 orsomething like that in most homes. It's immaterial now,but you could see you in five yearsthere's a new voice search interaction interfaceand it's not Google in the home. Thatcould be a real challenge for the company." Andhe was basically positing, "What are you guys doing about all of the virtual-assistant and smart-home devices?"

Priestley:Yeah,great question.

Lewis: Yeah. AndSundar Pichai,Google CEO,he gave that generally positive answer,talking about the investments the company is makingand how they're working toward voice search, and how they're trying to meet consumersin 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 isgetting at this idea of: Amazon's Echodevices are selling like hotcakes. If the installed base for them,or really any other virtual assistant, getsmassive, and consumers start using those devicesfor the types of things and the purposes thatpeople are generally using Google mobile anddesktop 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 industryconference, there was an AmazonVPtalking about some of the capabilitiesand some of the opportunitiesthat Amazon might explore. That ledsome analysts to speculate thatthe 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, andhow people are using home assistants orvirtual assistants. Because,if we see that slowly eat intowhat would otherwise be desktop or mobile search,you have to wonder about how that mightimpact Google's core business, and reallywhat prints money for them and allows them to fundall of these other projects.

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

Lewis: Yeah. If people are using Nest or GoogleAssistant, then yeah, not a huge problem,that will keep them within that ecosystem. If they are using products that don't lean onGoogle search, and you have platforms that areable to monetize that search,Google might get crowded out a little bit. Again, Google did $26 billion in revenue this quarter. Thevast majority of that was online ads. It's a huge market. I think people's more in-depth searching, or more research-based stuff, isalways going to be on desktop or mobile. You can only glean so much from audio. Butif you want the quick answer on something -- sayyou 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'ssomething to keep in mind. Again, this is a five, 10-year risk. But, just,investors, keep an eye on what's going onwith 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'sso magnanimous of you.

Well, listeners, thatdoes 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 industryfocus@fool.com. 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!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Sarah Priestley has no position in any stocks mentioned. Dylan Lewis owns shares of Alphabet (A shares) and Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Apple, Mastercard, PayPal Holdings, and Visa. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.