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Alphabet (GOOG) Q3 2016 Results

Ruth Porat – CFO Alphabet, Inc.

Our revenue of $22.5 billion in the third quarter underscores the terrific performance of our businesses globally. For the quarter, our consolidated revenue grew 23% in constant currency versus last year, notwithstanding a challenging year-on-year comparison. Once again, the primary driver was Mobile Search, with ongoing strength in YouTube and important contributions from programmatic advertising and Play.

I’m going to present to you in the following order. First, review the quarter on a consolidated basis for Alphabet. Second, review the results for each of Google and Other Bets. Finally, I will conclude with our outlook. Sundar will then review our business and product highlights for the quarter, after which we will take your questions.

Beginning with a summary of Alphabet’s consolidated financial performance, total revenue was $22.5 billion, up 20% year over year and up 4% sequentially. We realized a negative currency impact on our revenues year over year of $196 million or $91 million after the benefit of our hedging program. Holding currency constant to prior periods, our total revenue grew 23% year over year and increased 5% sequentially.

Alphabet revenues by geography highlight the strength of our business around the globe. U.S. revenue was up 22% year over year to $10.6 billion. UK revenue was up 5% year over year to $1.9 billion, reflecting the meaningful impact of the decline in the British pound relative to last year. In fixed FX terms, the UK grew 18% year over year. Rest-of-world revenue was up 22% versus last year to $9.9 billion. In fixed FX terms, revenues were up 25% year over year.

GAAP other cost of revenues was $4.5 billion, up 30% year over year. Non-GAAP other cost of revenues was $4.2 billion, up 29% year over year, primarily driven by Google-related expenses, specifically costs associated with operating our data centers, including depreciation, and content acquisition costs, primarily for YouTube.

GAAP operating expenses were $8 billion in the quarter, up 15% year over year. Non-GAAP operating expenses were $6.5 billion, up 13% year over year.

On a GAAP basis, operating income was $5.8 billion, up 22% versus last year. The operating margin was 26%. Non-GAAP operating income was $7.6 billion, up 24% versus last year. The operating margin was 34%.

Stock-based compensation [SBC] totaled $1.9 billion, up 30% year over year and up 24% sequentially, primarily reflecting the step-up from our annual equity refresh for employees at the start of Q3.

Headcount at the end of the quarter was 69,953, up 3,378 people from last quarter. Headcount growth is typically seasonally highest in the third quarter as new graduates join. Consistent with prior quarters, the vast majority of new hires were engineers and product managers to support growth in priority areas such as cloud.

Other income and expense was $278 million. We provide more detail on the line items within OI&E in our earnings press release.

Our effective tax rate was 16%.

Net income was $5.1 billion on a GAAP basis and $6.3 billion on a non-GAAP basis. Earnings per diluted share were $7.25 on a GAAP basis and $9.06 on a non-GAAP basis.

Turning now to CapEx and operating cash flow, CapEx for the quarter was $2.6 billion, the substantial majority of which supported the Google segment. Operating cash flow was $9.8 billion, with free cash flow of $7.3 billion. We ended the quarter with cash and marketable securities of $83.1 billion, of which approximately $50 billion or 60% is held overseas.

Let me now turn to our segment financial results, starting with the Google segment. Revenue was $22.3 billion, up 20% year over year, which includes the impact of FX. In terms of the revenue detail, Google Sites revenue was $16.1 billion in the quarter, up 23% year over year and up 4% sequentially. Year-on-year growth reflects strength in Mobile Search. We continue to have decent growth from desktop and tablet search.

YouTube revenue continues to grow at a very significant rate, driven primarily by video advertising across TrueView, with a growing contribution from buying on DoubleClick Bid Manager.

Network revenue was $3.7 billion, up 1% year on year and flat sequentially, reflecting the ongoing strong growth of programmatic and AdMob, offset by the traditional network businesses. Other revenue for Google was $2.4 billion, up 39% year over year and up 12% sequentially. Year-over-year growth was driven by Play and Cloud.

Finally, we provide monetization metrics to give you a sense of the price and volume dynamics of our advertising businesses. You can find the details in our earnings press release. Let me remind you that these metrics are affected by currency movements.

Total traffic acquisition costs [TAC] were $4.2 billion or 21% of total advertising revenue, up 17% year over year and up 5% sequentially. The increase in both Sites TAC as a percentage of Sites revenue as well as network TAC as a percentage of network revenue reflects the fact that our strongest growth areas, namely Mobile Search and programmatic, carry higher TAC. Total TAC as a percentage of total advertising revenues was up slightly sequentially as a result of higher TAC for Mobile Search offsetting the benefits of a revenue mix shift from network to Sites.

Operating income excluding SBC was $8.4 billion, up 19% versus last year, for an operating margin of 38%. Google’s stock-based compensation totaled $1.6 billion for the quarter, up 28% year over year. Operating income reflecting the impact of SBC was $6.8 billion, up 17% versus last year, and the operating margin was 30%. CapEx for the quarter was $2.4 billion, reflecting investments in production equipment, facilities, and data center construction.

Turning to Other Bets, as we said previously, we think it remains most instructive to look at financials for Other Bets over a longer time horizon because, as you have seen, quarterly revenues and expenses can be lumpy for three primary reasons. First, the Other Bets are early-stage. Second, they represent an aggregation of businesses operating in different industries. And finally, they may be impacted by one-time items like partnership deals.

For the third quarter, Other Bets revenue was $197 million, primarily generated by Nest, Fiber, and Verily. Operating loss excluding SBC was $665 million in the third quarter. Including the impact of SBC, operating loss was $865 million. Other Bets CapEx was $324 million in Q3, primarily reflecting ongoing investments in our Fiber business.

I’d like to close with a few observations on our progress since the creation of Alphabet just over a year ago as well as a review of our key themes. As we’ve frequently noted, our move to Alphabet was motivated by our belief that revolutionary ideas drive the next big growth areas. Long-term success requires a commitment to making bets, putting the right talent and resources behind those bets, and remaining flexible and dynamic as we pursue them. We believe our structure provides the transparency and oversight needed to make smart choices about our investment opportunities both within Google and across Other Bets.

As we reach for moon shots that will have a big impact in the longer term, it’s inevitable that there will be course corrections along the way and that some efforts will be more successful than others. Over the past year, for example, you’ve seen us make progress and accelerate our efforts in some areas while repositioning or taking a pause in others. We are taking the steps necessary to lay the foundation for a stronger future.

Looking ahead, first regarding revenue, our revenue growth reflects our sustained investment in innovation. Within Google, this relentless focus has led to innovations across our advertising platforms that have driven continued strong growth on a very large base, while at the same time we’re building new businesses to serve as sources of future revenue growth. Most notably, Google Cloud is generating substantial revenue growth, reflecting the ongoing momentum in the business as well as the enormous opportunity in this area. And earlier this month, we launched a new line of hardware devices that, for the first time, brings consumers the best of Google through both hardware and software developed by Google.

As discussed previously, because most of our Other Bets are pre-revenue, the Other Bets revenue line provides only partial insight regarding our progress, which we aim to supplement with insight regarding product progress. For example, at Nest, product innovations and improvements, including the new outdoor version of the Nest Cam, are leading to increased consumer adoption of its suite of products for the home. Our self-driving car team is making terrific progress in transforming mobility, with our fleet of test cars recently passing the 2 million-mile mark of autonomous driving. We are now testing our cars in four cities, enabling us to experience varied weather and driving conditions.

Second, as to expenses, as I mentioned last quarter, there are a number of factors driving higher TAC in both our Sites and network businesses, and those factors persisted in the third quarter. The shift to mobile in Q3 remained the largest driver of the increase in Sites TAC as a percentage of revenue. We expect Sites TAC to continue to increase as a percentage of Sites revenue. The growth in network TAC in Q3 was due to the ongoing adoption of programmatic platforms by advertisers, which are subject to a higher TAC rate, a trend we expect to continue. Furthermore, with respect to Google’s operating expenses, we remain committed to investing in the compelling opportunities we’ve identified.

 Turning to Other Bets, we’re building out these businesses systematically and thoughtfully, investing commensurate with requirements given the opportunities we see.

Before moving on from expenses, one reminder regarding the fourth quarter; as discussed in prior years, our marketing costs are typically weighted more heavily toward the back half of the year due to the holiday season. Relative to last year, we have an expanded portfolio of hardware products, and therefore expect marketing costs to increase in the fourth quarter to support the line.

Third regarding CapEx, at Google the team continues to drive meaningful efficiencies in planning and operations for our technical infrastructure. With regard to CapEx investments for Other Bets, our Fiber investment remains the primary driver.

Fourth, our balance sheet; our balance sheet remains a powerful tool reflecting the strength of our cash flow and thereby giving us the ability to invest aggressively to support our long-term growth. Our primary focus is just that, investing in the breadth of opportunities across Alphabet. As discussed previously, our capital allocation framework begins with our outlook for the businesses, including a sensitivity analysis regarding potential CapEx and M&A, as well as a view regarding working capital and a prudent liquidity buffer. This framework further considers complementary uses such as the share repurchase. As announced today our board has authorized us to commence a repurchase of our Class C capital stock of up to $7,019,340,976.83.

In conclusion, in the third quarter we again delivered strong revenue growth while broadening our portfolio of products and services. Thanks to all of our colleagues around the globe for their ingenuity and passion for pushing the frontier.

Read more of the Q3 2016 earnings call transcript on Seeking Alpha