Alphabet Isn't Quite Clicking on All Cylinders

In this MarketFoolery video segment, host Chris Hill and Supernova and Rule Breakers' David Kretzmann dig into the details of Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) second-quarter report, which certainly had its positive notes: How does a company this size grow revenue 22% in a year? The answer -- unfortunately for shareholders, who took a bit of a loss on the day -- is that it buys that growth, at an ever higher cost. Still, given all the things it's doing right, that's no reason to be a pessimist.

A full transcript follows the video.

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This video was recorded on July 25, 2017.

Chris Hill: Let's move over to Alphabet. Second-quarter revenue grew 21%, also an astonishing number when you consider just how big Alphabet is, and how much money that company makes. But the share's down a little bit today. Some of the key metrics are going in the wrong direction, and top of that list is cost per click.

David Kretzmann: Yeah, cost per click is down 26%. That is sort of made up with the volume of clicks. Paid clicks overall are up 52%. So you're seeing the number of clicks going up, but the cost per click is going down. So you're seeing some pressure on margins there, but that has been an ongoing trend. So that isn't necessarily anything new. If you look at just the Google segment, that's the core advertising segment for the company, it makes up about 90% of total revenue -- that segment's revenue was up 21%, but the traffic acquisition costs, essentially the cost to get that revenue, grew 28%. So you're seeing that pressure on margins, but like I said, I don't think this is anything necessarily new to worry about. If this becomes an ongoing trend where you're seeing the costs rise and revenue continue to decelerate, then that might be something you need to take a step back and look at.

But at this point, for one quarter's results, I think there's still a lot to like with this company. I still have Alphabet at the top of my list for the company to hit the trillion-dollar mark first. I think a lot of people look at Apple, Amazon, and Alphabet as the strongest three contenders, or certainly of the top five contenders to hit that trillion-dollar mark. But I look at Alphabet, and they're growing their top line at about the same pace as Amazon, around 22%. That's been pretty consistent over the past five years. The companies are neck-and-neck in terms of revenue growth. In terms of valuation, Alphabet's valuation is a lot more reasonable. They're producing twice the operating cash flow and free cash flow of Amazon.

So this is still an incredibly powerful business. You obviously have some regulatory headwinds with the EU's decision to stick Google with a $2.7 billion fine. The company has plenty of cash, over $90 billion in net cash, so they can afford that. But there is that regulatory risk with Alphabet, and potentially increasingly with Amazon as well. So that'll be something to watch.

Hill: The EU fine that they paid, the $2.7 billion, am I correct that all of that was accounted for in this quarter?

Kretzmann: Yeah. If you just take an apples-to-apples comparison from this quarter and last quarter, it'll show their net income and operating income basically getting sliced a good amount and dropping. Hopefully that's a one-time event. It should be a one-time event. So when you back that out, it's still a very solid quarter in terms of free cash flow and earnings. Things are still by and large great for the company. One area that I see a lot of promise and continue to see a lot of promise in is with YouTube, which now has 1.5 billion monthly viewers. People spend an average of 60 minutes a day on their phones and tablets watching content on YouTube. They mentioned that the fastest-growing place to watch YouTube content is actually in the living room on a TV through a streaming device like Roku. So people are increasingly engaging with YouTube, so I think that property alone is incredibly valuable. Then you have Google Photos, Google Maps, you have these properties that, I think they've done an incredible job from a user-experience perspective. You're seeing that engagement continue to increase across the board.

Hill: One item that has been resurrected is Google Glass, making a comeback for businesses, essentially.

Kretzmann: The enterprise, yeah. I think it was a Wired article from a week or two ago. There's a manufacturing facility in Minnesota where the workers are using this to help them with measurements and dimensions of whatever they're working on. It's a quick way to pull up that info. There's certainly still a future for augmented reality. I think Google was several years early on the consumer side, but there's still potential there. And they're also working on something called Google Lens, which I think, over the next few years, this could become a huge driver for the company. I think we'll hear more and more about it. It's essentially an augmented-reality photo search. Imagine that you have your phone, you hold it up to a flower, and it'll tell you what kind of flower that is. Or you hold it up to a restaurant, and it'll immediately on the screen pull up the reviews, something like that. It's essentially using the camera as a search device and as that filter. So they have this Google Lens product where, they're testing it, and they're still very early, as far as that product development goes. But I think that's something we'll see more and more of in the next few years.

Hill: Going back to YouTube for a second, I would happily send the people the people at Groupon $20, I would kick in $20 if they would just stop running their YouTube ads. It has this annoying singsong thing. They're really the worst.

Kretzmann: I've heard that one, yeah. It's not good.

Hill: Yeah, you know the one. Anyone who's been on YouTube and has encountered a pre-roll Groupon ad knows exactly what I'm talking about. I was thinking about this this morning.

Kretzmann: But you remembered it, so maybe it worked.

Hill: I remembered it, but I've also taken time to figure out the name of the ad firm and email them and be like, "Please stop. Please just stop."

Kretzmann: Wow, good for you.

Hill: But I was thinking, if you're doing the spectrum of video advertisements, whether it's YouTube or just what we think of in terms of traditional television advertising, at one end of the spectrum, I think you have Nike. Whoever does Nike's commercials, that to me is the gold standard. They are phenomenal. At the other end of the spectrum is Groupon.

Kretzmann: That's a spectrum there.

Hill: Yeah, instead of a scale from 1 to 10, it's, how good is this ad on a scale from Groupon to Nike?

Kretzmann: With the Nike ads or some of those old Apple ads, you'll actually search for them on YouTube to watch them. That's the gold standard. What's interesting about that is, YouTube no longer runs 30-second ads. They found those ads do not perform well. No one wants to sit for a 30-second ad before watching a two-minute video on YouTube. But they are seeing more and more success with, they're calling it six-second bumper ads. It's a quick-hitting ad right before the video. More brands are testing that out. I think, as they test out more ad formats like that, you will see the value, the cost per click, for YouTube, go up. I think there's a lot of value in that platform, because when you have such an engaged audience, you can test different formats for those ads, and I think those ad spaces will become more valuable over time. But you'll have to go through some quarters like this where they're still figuring it out. But the platform itself is growing, and for patient shareholders, that's what counts.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Chris Hill owns shares of Amazon. David Kretzmann owns shares of Alphabet (C shares), Amazon, and Nike. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and Nike. The Motley Fool has a disclosure policy.