A logo stands above the entrance to Google Inc.’s Kings Cross office in London, U.K. (Photographer: Simon Dawson/Bloomberg)

Alphabet Revenue Misses Estimates While Payouts to Partners Rise

(Bloomberg) -- Google parent Alphabet Inc. is paying more to partners that distribute its search engine, while charging less for each ad that it runs -- a combination that’s putting a damper on growth.

Third-quarter sales, minus partner fees, were $27.2 billion, the internet giant said Thursday in a statement. Analysts on average were expecting $27.3 billion, according to data compiled by Bloomberg. Sales from Google’s own properties, including YouTube and search pages, rose 22 percent, slower than the 26 percent growth in the prior quarter. The company’s shares slid in extended trading.

Google is shelling out billions of dollars a year to partners including Apple Inc. to distribute its search engine widely. Then it’s up to Google to generate as much money as possible when people search and click on relevant ads. More of these marketing spots are running on mobile and YouTube, which can’t charge as much as the company’s original desktop search business because they result in fewer eventual consumer purchases.

"It’s a light top-line number," said Ron Josey, an analyst at JMP Securities. "This is the first quarter in a while where growth decelerated."

The number of clicks on Google ads jumped more than 60 percent in the quarter, but prices dropped 28 percent. That’s the biggest decline since at least early 2015, according to data compiled by Bloomberg.

Alphabet Revenue Misses Estimates While Payouts to Partners Rise

Alphabet shares dropped 3.9 percent in late trading after the report. Earlier, the stock jumped 4.4 percent to $1,103.59 in New York.

Google can’t charge customers as much for mobile search ads and YouTube spots because they offer lower returns on investment for advertisers, according to Sameet Sinha, an analyst at B Riley FBR Inc. People are less likely to buy something after clicking on these marketing messages, at least compared to Google’s original desktop search ads, he said.

Audience targeting has historically helped raise the price of Google search ads. One feature, called remarketing lists for search ads, or RLSAs, let advertisers adjust Google campaigns based on whether a user has visited their website or app before and what they did there. But an Apple privacy feature called Intelligent Tracking Prevention was updated in mid-September and appeared to disrupt advertisers’ ability to use Google’s RLSAs, at least temporarily, ad agency Merkle Inc. said in a recent report.

Alphabet’s third-quarter net income came in at $13.06 a share, ahead of analysts’ average estimate of $10.45. Accounting gains from the valuation of Alphabet’s many startup investments added more than $1 billion to profit, and the company’s tax rate dropped from a year ago.

While third-quarter sales and profit jumped, so did costs. Capital expenditures totaled $5.28 billion in the quarter, up 49 percent from a year earlier. The company is spending billions of dollars a year to build data centers, while developing and marketing new consumer hardware like its Pixel phones.

"The company is on track to spend a greater share of its revenue on capex than in any year since 2014 at its current pace," Brian Wieser, an analyst at Pivotal Research Group, wrote in a note to investors. "Much of the investment is reinforcing businesses in global markets which probably aren’t particularly large or won’t be profitable any time soon."

The sums Google pays partners to distribute its search engine and ads -- called traffic acquisition costs -- rose 20 percent to $6.58 billion. That was 23 percent of ad revenue, unchanged from the second quarter. Chief Financial Officer Ruth Porat said TAC for Google’s own sites, like search, will continue to rise as more people use mobile devices and the company has to pay partners to reach them.

On top of higher partner fees, rising costs and a lower average cost-per-click, the company is also facing a regulatory backlash in Europe, questions about its data-collection and privacy practices, and clashes with advertisers over inappropriate content on its YouTube video-sharing site. U.S. President Donald Trump has accused Google’s search engine of being politically biased, while there are calls for more antitrust scrutiny and a privacy law in the U.S. to control how internet companies collect data on consumers.

On July 18, Google was fined a record $5 billion by Europe’s antitrust authorities for violating competition law with its Android mobile operating system. The company’s shares are down about 10 percent since then, although that’s coincided with declines in other tech stocks and the broader equity market.

To comply with the antitrust decision, the Mountain View, California-based company will start charging Android phone makers in the region for a group of mobile apps that includes its Play app store. Manufacturers will pay as much as $40 per device, the Verge reported last week. That upends a decade-long strategy of providing Android and Google apps free and using the operating system to distribute its profitable search engine and Chrome browser. Europe ordered Google to stop forcing phone makers to pre-install search and Chrome, so the company now needs another way to generate revenue from Android in the region.

Google Chief Executive Officer Sundar Pichai said on the conference call that it’s "difficult to predict how the pricing model will be accepted."

Google also plans to pay handset makers in Europe to continue to pre-install Search and Chrome. This could add to the traffic acquisition costs that investors and analysts watch so closely.

The company’s "other revenue" bucket, which includes cloud, hardware and app sales, grew 29 percent to $4.64 billion in the period. Google Cloud Chief Executive Officer Diane Greene has been aggressively pursuing new corporate customers, but the business still lags behind Amazon Web Services and Microsoft Corp.’s Azure.

Other Bets, the home of Alphabet’s riskier, experimental businesses, lost $727 million in the quarter, wider than the $650 million loss in the same period a year earlier. Revenue in that division rose to $146 million.

Alphabet’s most-promising Other Bet is the Waymo autonomous vehicle unit, which is preparing to launch a paid service in the Phoenix area later this year. That will be a major step for business that’s mostly been an expensive R&D project for a decade. Morgan Stanley recently estimated an enterprise value of as much as $175 billion for the division.

©2018 Bloomberg L.P.