Pedestrians are reflected in a window looking into a lobby of the Google Inc. offices in New York, U.S. (Photographer: Michael Nagle/Bloomberg)  

Alphabet Earnings: Google's Spending a Lot and Wants Some Trust

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(Bloomberg Gadfly) -- Google parent company Alphabet Inc. is growing faster than nearly all companies of its size. And its spending is growing even more quickly. The message from executives on Monday was clear: Alphabet is entering a period of serious investment, and investors should be happy about it. 

Alphabet disclosed its strategy in its first-quarter financial results, and it provides a test of investors’ faith. Essentially, Alphabet is taking a page from the Amazon.com Inc. playbook: Tell investors the company is going to spend lots of money on promising current and future business opportunities and demand that investors give it leeway to keep doing it.

Hey, it worked for Amazon, a company that doesn’t have nearly  the profit cushion that Alphabet has. It’s a risky tactic for Alphabet, which has a recent history of lavish spending without a solid payoff. But assuming Alphabet discloses more details about its business as it cranks up the spending machine, the company has earned an Amazon-like benefit of the doubt.

Here's a glimpse of Alphabet's more spendthrift ways: The company’s first-quarter capital expenditures -- or the spending for major projects such as real estate properties and computers -- nearly tripled in one year to $7.3 billion. The company said about $2.4 billion of that figure was for the purchase of the Chelsea Market building in New York City, a well-known, valuable property that houses Google employees as well as other retail and commercial operations.

Even excluding that purchase, though, Alphabet's first-quarter capital costs of $4.9 billion still roughly doubled in the last year, and it’s more than the average Wall Street estimate of Exxon's capital spending for the same period, according to Bloomberg data. And Exxon does the high-intensity work of drilling oil and gas out of the ground, while Google flings virtual pixels. 

Ruth Porat, Alphabet's chief financial officer, told analysts on Monday that capex was almost evenly split between physical real estate and computing capacity that needs constant refreshing to make it as state of the art as possible. She said the company prefers to own rather than lease real estate when it sees good opportunities to do so. 

 

Alphabet's 23.5 percent jump in net revenue was the fastest pace since 2014, but its operating costs jumped even more. Its 22.5 percent operating profit margin was Alphabet's smallest since 2012. The operating profit included a performance fee related to equity investments that weighed down the margin.

Alphabet made it clear that the company's upward spending trajectory would continue. "The opportunity set ahead of us is quite extraordinary, and we remain focused on investment to support long-term revenue and profit growth," Porat said on a conference call with analysts. “We have both the business confidence to invest appropriately in the next phase of innovation as well as clarity about some very compelling opportunities.”

In case you don't speak CFO, she means Alphabet is going to lean into spending and thinks the company has earned the trust of investors to do so. It's straight out of the successful playbook of Amazon, which has single-digit operating profit margins if it has any margin at all. Alphabet's margins are enviable by comparison. Porat is right to demand Alphabet stockholders cut it some slack on spending, but that doesn't mean investors shouldn't question whether Alphabet is spending the right amounts on the best projects. 

Investors would be forgiven if they are having uncomfortable flashbacks. Before Porat was hired at Google in 2015, the company's spending had gotten a little out of hand, and her hiring was seen as a sign that Google was eager to become more disciplined. Stock investors rewarded Google with a significant jump in its share price. What's different now is that Alphabet’s revenue is growing faster than it was when Porat came on board, and that should give shareholders some comfort that executives know what they’re doing. 

Alphabet could help win over investors, however, by giving them something in exchange for their good faith in management's fiscal prudence. Alphabet discloses almost nothing about its business. No one knows how much revenue YouTube generates, for example, or how the company generates profits from the Android software for which it doesn't charge a licensing fee to smartphone companies. Alphabet could disclose more about the revenue and profits of its cloud-computing business, too, something the company has started to do haltingly.  

Alphabet shares were roughly flat in after-hours trading Monday, and it will be interesting to see whether investors buy the company's “trust us" message. The company could also help itself by giving more of a glimpse inside of its financial black box. 

Shira Ovide is a Bloomberg Gadfly columnist covering technology. She previously was a reporter for the Wall Street Journal.

©2018 Bloomberg L.P.

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