Alphabet, Baidu & Amazon – West vs. East.

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US fares far better than China.

  • Alphabet and Amazon reported very strong results while Baidu struggled to deal with the shift in advertising from search to social media.

Alphabet.

  • Alphabet reported another very strong quarter but the requirement to share some of the spoils with its partners is putting upward pressure on costs.
  • Q3 17A revenue-ex TAC / EPS were $22.3bn / $9.57 compared to consensus at $22.1bn / $8.32.
  • The better than expected profitability was largely driven by the reduction of losses at Other Bets as costs at the fibre init were cut and other investments were more fiscally prudent.
  • Revenues were once again mainly driven by mobile advertising which carries a much higher traffic acquisition cost (TAC) as Google has to share revenue with its partners.
  • This climbed to 23% of revenues up from 21% a year ago.
  • This combined with many fewer rumblings of dissent coming from Android handset makers these days and automakers saying that Google is being nicer to them, leads me to believe that Google is sharing more of the spoils with its long-suffering partners.
  • Alphabet admitted as much on the call mentioning that some of the agreements with its partners had been changed.
  • I suspect that this also has something to do with the prospect of the EU forcing Google to change its business model which is likely to be less severe if its partners are happy.
  • I suspect that this trend is likely to continue and the outlook for Alphabet going into Q4 17 and 2018 remains healthy.
  • That being said, the valuation has kept largely in step with the fundamental improvement in its business leaving me indifferent to the shares.

Amazon.

  • Amazon’s haphazard approach to making money surprised the market once again but I suspect that investments in Q4 17 will once again depress earnings.
  • Q3 17 revenues / EBIT were $43.7bn / $347m compared to estimates of $41.3bn / $223m.
  • It was the unexpected profit that once again lifted hopes that Amazon has become sustainably profitable.
  • As usual it was AWS that drove profits with revenues of $4.6bn and margins of 25.5%.
  • This masked ongoing massive investments outside of the US where losses mounted to $936m (6.8%) from $541m (5.1%) one year ago.
  • I suspect that the vast majority of this is being spent in India where Amazon is absolutely determined not to lose out to local players following its ignominious defeat at the hands of Alibaba in China.
  • This is why I am extremely cautious on the outlook for Flipkart and Snapdeal as Amazon has the financial resources that its rivals lack despite huge investments from Softbank.
  • Amazon is guiding for strong sales in Q4 17 but I think that it could easily miss its profitability forecasts as has become customary.
  • Q4 17 revenues / EBIT are expected to be $56.0bn – $60.5bn / $300m – $1.65bn slightly ahead of consensus at $55.5bn / $1.5bn.
  • Amazon is continuing to grow its revenue base very successfully but I still can’t get comfortable with investing in shares where one is already paying for profitability that remains random and illusive.

Baidu.

  • Baidu reported poor results that triggered a big sell off creating what is probably the cheapest AI investment on the planet.
  • Q3 17 revenues / net income were RMB23.5bn / RMB7.9bn beating estimates of RMB23.5bn / RMB4.4bn but the better than expected profits were driven by a non-operating gain of RMB4.2bn.
  • Removing this and adjusting for tax reveals a much more sombre picture and the reality that R&D spending is outstripping sales growth as these investments have yet to bear fruit.
  • At the same time, the company guided weakly for Q4 17 with RMB22.2bn – RMB23.4bn of revenues expected, again missing estimates of RMB25.0bn.
  • This weak performance came on top of a 7% fall in the total number of advertisers using Baidu to 486,000 raising legitimate concerns around long-term growth.
  • These advertisers are becoming more interested in spending their money on social networking platforms where the likes of Tencent have woken up to the revenue potential that their services create.
  • Consequently, the short to medium term outlook for Baidu remains uncertain which resulted in the big sell off seen following the numbers.
  • However, it is not all bad news as RFM ranks Baidu as No. 2 globally in AI which is currently the most sort after (and hence the most expensive) skillset in the technology industry today.
  • This capability has been created from 20 years of crunching data which has allowed Baidu to create the best digital assistant in China (Duer) as well as the most advanced Chinese autonomous driving offering.
  • Unfortunately, all of these investments have yet to bear fruit in terms of tangible revenues meaning that short-term minded investors will continue to ignore them.
  • This creates an opportunity for those wanting to invest in AI to get into something at a very reasonable price.
  • The issue is that without any visibility on when these investments will bear fruit and the uncertainty around the core business, the right time to make this investment is clearly not now.
  • I have liked Baidu given is relative valuation to its Chinese peers and leadership in AI but these results indicate that it is likely to be very volatile for the next few quarters.
  • Tencent looks like a safer place to be for now.

RICHARD WINDSOR

Richard is founder, owner of research company, Radio Free Mobile. He has 16 years of experience working in sell side equity research. During his 11 year tenure at Nomura Securities, he focused on the equity coverage of the Global Technology sector.