Alphabet drops after reporting lower Q2 profit on huge EU fine

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GOOGL 2Q17 Results Reflect Impact of EC Fine, But Should Show Steady Growth:

While GOOGL continues to realize steady growth in its core advertising operations (Google sites +21.7% y/y), investors are slightly concerned about the potential longer-run impact of the EC investigation into whether GOOGL’s practices are anti-competitive. Note that 2Q17 EPS will reflect the cost of the $2.7bn fine (EPS impact -$3.90) the EC levied regarding Google Shopping, but there likely to be future costs as GOOGL now faces potential civil litigation along as yet undefined increased EC oversight. Note as well that the EC investigation of Android & AdSense is still ongoing, and uncertainty around timing & magnitude of the impact from the expected ruling remain an overhang. While Google Shopping is a relatively small portion of total sales (est. 3-4% of gross revenue), the fact more significant portions of GOOGL operations are under EC scrutiny does constitute increased risk to investors. This is the backdrop against which investors will assess GOOGL’s 2Q17 results (Street revs $25.7bn, +19.3% y/y; EPS $4.46, -47.0% y/y (ex-EC fine -1% y/y)).

The two major questions investors will want GOOGL management to address are:

1) How will GOOGL get more share of traditional television advertising spend over time? and
2) What can be the next big growth driver (e.g. Cloud, Maps, Hardware, Waymo) for GOOGL further out? See here for insight on GOOGL Cloud competitive positioning: https://www.g2crowd.com/categories/cloud-platform-as-a-service-paas

Once 2Q17 Earnings Season Over, Investors Should Focus on Names With Rising Profit Margins Off Increasing Sales:

Coming out of the June 2017 tech pullback, we note that the sector benchmark Technology Select Sector SPDR ETF (XLK) is up +3.16% since 6/12/17, continuing to lead the broader S&P500 (+1.63%) with 5 stocks (AMZN, FB, GOOGL, MSFT, NFLX) outperforming by a wider margin (+10.25%). Factors supporting both the tech sector and broader market gains have been the prospects for: 1) regulatory reform, 2) corporate tax rate reduction, 3) overseas profit repatriation, and 4) higher GDP growth. We caution that diminished political prospects may cap the sector’s rebound once 2Q17 earnings season is past and that investors should be selective.

Meanwhile, to that end, the table below shows the current next quarter growth forecast for sales and earnings for tech sector leaders along with the percentage decline of their shares from their respective 52-week highs and the P/E/G (price/earnings/growth rate) ratio contrasting the current 2017 P/E ratio with the EPS growth rate over the 2016-2018 timeframe. With possible concerns around economic growth, it is important investors consider those names where profit margins are expanding (i.e. EPS growth greater than sales growth) over names where profit margins are under pressure or where EPS are seeing outright declines. When faced with uncertainty, selectivity is critical to preserving capital and, along with it, performance.