Google Q2 Earnings: Peak Dollar Strength And TAC (NASDAQ:GOOG)

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Leon Neal

Q2 recap and Thesis

My last article on Alphabet Inc. (NASDAQ:GOOG)(NASDAQ:GOOGL) focused on its long-term prospects. The article argued for its perpetual compounding power. In this article, given that it just announced its Q2 earnings, I wanted to shift the focus and share my thoughts on its Q2 earnings.

GOOG reported double-digit topline growth both at an overall level and also in all its key segments. Total revenues grew by 12.6% to $69.69B as you can see from the following chart. Even though the numbers missed consensus estimates of $69.8 by a thin margin, the market welcomed its double-digit growth, especially the strength of its search and cloud segment. Furthermore, the revenue growth would have been 16% on a constant currency basis. The recent surge in dollar strength impacted its earnings by about 3.4% negatively. And we will elaborate on this more in the next section.

Despite the healthy growth in the top line, its bottom line is under the same pressure. As you can see, the operating margin contracted by 3% to 28% this quarter from 31% last year. As a result, net income decreased despite the topline growth. A few factors contributed to the margin pressure besides currency headwinds. The leading factor in my mind is the traffic acquisition costs (“TAC”) as to be detailed later.

Overall, I see the business fundamentals as resilient and the valuation very reasonable at this point. And I’m maintaining my bullish thesis.

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Google Q2 Earnings report

Currency exchange headwinds

As a global business, GOOG has a large exposure to currency rates like other tech giants. To wit, its revenue from the U.S. is only a relative minority (45%) in its income mix in 2021 as you can see from the following chart. Europe, the Middle East, and Africa is its next largest revenue contributor (31%), followed by the Asia-Pacific region (contributing 19%).

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Source: businessquant.com

Recently, the dollar has gained substantially over the major currencies from all the regions mentioned above. The dollar index (an average of its exchange rates versus a basket of other major currencies like those in the above regions) currently stands at 107.08, the highest level in about 20 years. The dollar index has gained a whopping ~18% since January this year. Due to its exposure, GOOG’s Q2 earnings suffered a 3.4% currency headwind. In constant currency, its revenues would have been up 16% instead of 12.6%.

However, I see the currency impact as temporary only. Looking forward, I see the dollar is losing steam for further strengthening now based on the following arguments detailed in my other article here.

I see short-term treasury rates (1-year, 2-year, and 3-year) have all reached their target ranges already. These rates have all reached their target range already in my view. The short-term rates are currently high enough to cause a yield curve inversion already. As a result, the dollar strengthening is losing steam as we go forward. And furthermore, I see unfolding geopolitical developments (such as China systematic reduction of its dollar assets) to further mute its strengthening.

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Source: investing.com

Margin pressure and TAC

Besides currency headwinds, a few other factors led to margin compression. If you recall from the first chart in the article, the operating margin contracted by 3% to 28% this quarter from 31% last year. As a result, net income decreased to $16B from $18.5B (a 13.5% decrease) a year ago despite the double-digit topline growth. And diluted EPS also decreased from $1.36 to $1.21 (by a smaller degree of 11% due to share repurchases).

To put things under a broader perspective, its operating margin has fluctuated in a range from as low as 16.7% during the COVID crash to as high as 32.3% with an average of 25% in the past 5 years. So, its current margin of 28% is still above its long-term average, but it’s something that needs to be monitored more closely.

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A few factors contributed to margin compression, and the most important one in my mind that deserves close attention is the traffic acquisition costs (“TAC”). Ultimately, GOOG is a website, which sounds like a truism. But sometimes we forget that because we are so used to landing on google.com and then let it lead us to other places. But it is a website and needs traffic too. And just like any other website (and many of them pay GOOG to attract traffic), it has to pay TAC to others. And the TAC cost is a substantial cost, even for GOOG. For example, in 2021, its TAC was over $45B, more than 21% of its total advertising revenues. A key contributor to GOOG’s success (at least so far) was its ability to control TAC costs thanks to its scale.

With the above background, you can see why I am more concerned with its TAC in recent quarters. Yes, it is good news that revenues have been positing healthy growth both at the overall level and in all key segments: Google Search & other grew 13.5%, YouTube 4.8%, Google Network 8.5%, and Google Cloud a spectacular 35.6%, et al. However, TAC also grew at a double-digit rate of 11.9% this past quarter, from $10.9B last year to $12.2B now.

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Google Q2 Earnings report

Final thoughts and other risks

Overall, I’m maintaining my bullish thesis on GOOG. Again, I see the currency headwinds are only temporary. And moreover, just like Warren Buffett, I do not recommend basing investing decisions on unpredictable factors like currency exchange rates. The TAC is a more concerning factor to monitor going forward. In terms of valuation, GOOG is currently trading at a discount relative to other peers. It’s trading at a P/E of 19.11x, about 20% cheaper than AAPL and 13% cheaper than MSFT. It is also cheaper than the tech sector represented by QQQ (which trades at 22.1x P/E according to Yahoo Finance). It’s debatable whether Google should trade at the same valuation as AAPL or MSFT. However, in my mind, I have little doubt that Google is better than the average business in the tech sector all around (profitability, moat, financial strength, et al).

Finally, besides the currency headwinds and cost issues mentioned above, there are also a few potential risks worth mentioning. There are also other factors that are likely to keep pressuring margins, such as rising expenses due to inflation and labor shortages. Also, it has been almost constantly facing regulatory pressure from government agencies both at home and abroad. Lastly, its number of employees increased by almost 30k over the past year. Its total headcount was 144,056 in Q2 2021 and now is 174,014, a more than 20% expansion. One in five of its employees was added over the past year. Such rapid hiring may have created some overcapacity that needs some time to be digested.

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