Alphabet sustained >20% constant currency growth for the 12th consecutive quarter, generating $33bn in gross revenue during 2Q18 and beating expectations on both top and bottom lines. We continue to see Alphabet as the dominant player in advertising -- digital or otherwise -- and expect the company to continue to take share of that market. However, gradually rising operating costs and significant ongoing capital expenditures lead us to our relatively neutral view on the stock. Our updated valuation is $1080 on a YE2018 basis vs. $1050 previously and we continue to rate the stock Hold.
Alphabet reported 2Q18 growth of +26%, similar to our forecast and ahead of StreetAccountconsensus of +26%. EPS was well ahead of our expectations and those of consensus at $11.75, excluding this year's multi-billion-dollar European Commission fine.
Alphabet reported constant currency growth of +23% for 2Q18, similar to growth observed in almost every quarter since 4Q15. Beyond ongoing market share gains in digital advertising, we think that relatively easy comparables because of last year's YouTube advertiser boycott and incremental revenue from GDPR probably helped as well. "Other" revenues -- 14% of the company's total, including Cloud, Play and Hardware -- collectively outperformed the company's overall growth rate with +37% growth year-over-year. We also think that ongoing shifts of search spending away from the network and towards the core site probably helped the reported "sites" line, while programmatic advertising undoubtedly grew substantially beyond the reported Network growth rate of +14%. There do not appear to be any signs that should cause a meaningful slowdown any time soon, as fines from the EC are not likely to hamper Alphabet's growth rate. Conversely, regulatory changes such as GDPR in Europe (and similar laws implemented elsewhere) could have the effect of reinforcing Alphabet's growth going forward unless regulators choose to more aggressively attack Alphabet's market co-dominance, which they may very well do at some point in the future. By region, growth was skewed away from the US and EMEA as APAC and Other Americas both grew by around +34% on a constant currency basis, similar to 1Q18 for Other Americas, but much faster for APAC. Operating income was also aided by $1.4bn, or $2/share, of other income, most of which was due to gains on equity securities.
On the cost side, TAC related to distribution was favorable, decelerating for the first time since early 2015, although it still rose +47%. TAC to network members also decelerated significantly to a +12% growth rate because of what the company described non-specifically as a favorable mix shift within its programmatic business. Operating costs as a percentage of revenues on an ex-TAC basis were down markedly, from 32.8% in 2Q17 to 30.0% this quarter. Taxes were higher than in recent periods at 24% of net income, although this is in part because the latest fine from EC was not tax deductible.
Beyond the operating results, we thought it notable that capital expenditures were up significantly, nearly doubling year-over-year to $5.5bn, equivalent to 17% of the company's gross revenue following an expenditure equal to 23% of its gross revenue in 1Q18. 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. To the extent that these efforts reinforce the company's long-term competitive position, they can be viewed positively, but on the other hand, we think much of the investment is reinforcing businesses in global markets which probably aren't particularly large or profitable any time soon.
On balance we view the quarter favorably for the company and raise our price target from $1050 to $1080 on a YE2018 basis.
VALUATION. We value Alphabet on a DCF basis. Our valuation incorporates a long-term 5.5% growth rate, a short-term 8.3% discount rate and a 11.3% long-term discount rate. Our price target on Alphabet is now $1080 and we continue to rate the stock Hold.
RISKS. Core risks for web publishers relate to: 1) high degree of rivalry in lieu of barriers preventing competition from emerging 2) high and increasing capital needs to remain and 3) government regulations and consumer pushback related to data management and privacy.
FULL REPORT INCLUDING RISKS AND DISCLOSURES CAN BE FOUND HERE: GOOGL 7-24-18.pdf
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