Why the Key To Alphabet's Future Success Isn't Advertising

Margins are shrinking in the mobile and YouTube segments, which is where the growth is. That means Google is going to have to find new and more profitable revenue and profit streams to maintain its dominance. JL

Jim Collins reports in Forbes:

The key factor in Alphabet's second quarter earnings was an increase in traffic acquisition costs (TAC) in the core Google search business. It's clear that pricing is coming down in the basic paid clicks space, and that is a result of both competitive pressures and a shifting revenue mix. Google charges a lower cost-per-click for mobile ads, and algorithmically-generated ads, called programmatic in the industry, are also lower priced than core desktop search query ads.

The key factor in Alphabet's second quarter earnings was an increase in traffic acquisition costs (TAC) in the core Google search business.  That increase in TAC combined with a lower cost-per-click produced margins below Street estimates and GOOGL shares dropped about 3% in after-hours trading Monday.
Analysts immediately flagged the lower-than-expected margins and Alphabet CFO Ruth Porat was straightforward in addressing the margin issue on the call.  Her response to a question from Doug Anmuth of JPMorgan clearly summarized Google management's philosophy:
"So starting with your margin question like as we've often said, we're focused on revenue and operating income dollar growth and not on operating margins."
It's clear that pricing is coming down in the basic paid clicks space, and that is a result of both competitive pressures and a shifting revenue mix.  Google charges a lower cost-per-
click for mobile ads, and algorithmically-generated ads, called programmatic in the industry, are also lower priced than core desktop search query ads.  Ms. Porat noted that the higher mix of mobile and programmatic negatively affected Google's cost-per-click in the quarter.
This is not a new phenomenon, and analyzing Google's metrics for the past 6 quarters (see below for the figures) shows a clear pattern of higher TAC and lower cost-per-click.  Also noted on the conference call was the marked increase in Google's headcount, with 75,606 employed as of June 30th, an increase of more than 9,000 employees versus the year prior.
So, net net, Google's segment operating margin declined to 30.3% in the quarter versus 32.8% in the year ago period.  The segment operating income excludes impact from the $2.74 billion fine imposed on Google by the EU--included in the "other" category--and shows the true impact of higher TAC, lower cost-per-click, and higher headcount.
The margin weakness pressured GOOGL shares in after-hours trading, but, again, listening to Ms. Porat's comments on the conference call, it is clear that GOOGL management is more interested in absolute dollar growth in revenues and profits than margin percentages.  I can't disagree with that strategy, and it certainly has worked not only at Google, but at other tech giants, notably Amazon.
That said, I believe analysts will have to closely revisit their earnings models for Alphabet after the earnings call.  The analyst consensus of $30.52 for EPS for 2017 may have to be tweaked, and the current consensus of EPS of $40.25 for 2018 seems very aggressive given the margin pressures facing the core Google search business.
Lowered earnings estimates are the most common cause for a high-flyer to lose that status, and with GOOGL shares having posted a 26% gain year-to-date, this would be a good time to take profits on the search giant's shares.
Year-over change in cost-per-click on Google properties:
2Q17  -23%
1Q17   -21%
4Q16  -18%
3Q16  -12%
2Q16  -8%
1Q16   -11%