Alphabet just released its 1Q 2018 earnings.
The stock market takes its stock price down.
After in-depth analysis, many Wall Street analysts blew this one. Alphabet had a very strong 1Q 2018.
Granted, Alphabet does a much better job operationally than it does in clearly writing its quarterly earnings releases. And if you don't have a strong background in Intermediate and Advanced Financial Accounting, you have absolutely no shot at properly interpreting its earnings releases.
Let me simplify its 1Q 2018 earnings release.
The key to understanding it is to recast Alphabet's 1Q 2018 income statement.
When I factor out the FASB accounting changes, here's what I get.
Total Revenues in the 1Q 2018 are up 26% over the 1Q 2017 ..... No other large company but Facebook is getting that kind of consistently spectacular revenue growth.
The first new FASB change related to Performance Fees Expense of $632 mil on its Equity Securities. Alphabet didn't disclose which specific expense line item it hit, but since its 1Q 2018 Cost of Revenues were up an extremely high 37.5% over the 1Q 2017, it only makes sense that this is where the $632 mil hit. Thus recasting the reported 1Q 2018 Cost of Revenues of $13,467 mil by reducing it by $632 mil yields $12,835 mil, which is up a much more reasonable 31% over the 1Q 2017.
Then recasting the reported 1Q 2018 Operating Income amount of $7,001 mil for the $632 Performance Fees Expense, yields recasted Operating Income of $7,633 mil, which is up 16.2% over the 1Q 2017.
Normally it's not good for Operating Income growth to be 10% lower than Revenue Growth. But this is where a smart computer software company makes its investments that drive that consistent 20%+ Revenue growth for many years into the future. Accounting rules are very conservative in requiring these investments in exceptionally effective and efficient computer scientists to be expensed right away, even though the value of their product is well into the future.
Further, as you will see later, a forward thinking company like Alphabet knows it already has its real 1Q 2018 earnings growth in the bag to more than offset the high growth in Investments in Operating Expenses.
The second new FASB change relates to the requirement to now reflect its Equity Investments at market price. The result was a 1Q 2018 Gain in Other Income and Expense of $3,031 mil. Obviously that is a good thing, but then you could see that it would get something like this when you reviewed Alphabet's 2017 annual report footnotes.
Thus recasting the reported 1Q 2018 of $3,542 mil Other Income and Expenses for this Gain of $3,031 mil yields a recasted 1Q 2018 Other Income and Expense of $511 mil, a bit higher than the $251 mil reported in the 1Q 2017. This is a line item companies frequently use to manage earnings.
Then recasting the reported 1Q 2018 Pretax Income of $10,543 mil for both the Performance Fees Expense of $632 mil and the Gain on Equity Securities of $3,031 mil yields a recasted 1Q 2018 Pretax Income of $8,144 mil, which is up 19.4% from the 1Q 2017.
Now for the dagger ..... Income Tax Expense ..... another line item companies frequently use to manage earnings.
Alphabet slickly was able to wash out the Income Tax Expense effect from the new FASB change on Equity Securities Gains and Performance Fees by using its Valuation Allowances on its Deferred Income Tax.
Thus, you don't need to recast its reported 1Q 2018 Income Tax Expense of $1,142 mil.
But the salient point here is that its 1Q 2018 effective income tax rate is only 14.0% ($1,142 mil/$8,144 mil).
And this yields recasted 1Q 2018 Net Income of $7,002 mil, which is up a very strong 29% over the 1Q 2017.
I can think of no other large company other than Facebook that can generate consistently real earnings growth of 25%.
So let's analyze the key effective income tax rates which were 20.4% in the 1Q 2017 and a much lower 14.0% in the 1Q 2018. This is what caused recasted 1Q 2018 Pretax Income growth of 19% to expand substantially to 29% recasted 1Q 2018 Net Income growth.
So, just how reasonable is that 6.4% drop in the 1Q 2018 effective income tax rate?
Well, the Statutory US Federal Income Tax Rate dropped from 35% in 2017 to 21% in 2018. So, US federal income tax paid and expensed will drop precipitously.
Also, you have to always think about the required amount of Income Tax Reserve Liability already on their books and the off-book additional potential amounts in their minds to cover future audits. The major problem large US multi-national Corps have here is the shifting of income to lower-taxed foreign countries. When the US statutory tax rate was so much higher at 35% than that in other countries, the necessary Income Tax Reserve Liability as well as the off-book additional potential amounts to cover audits are both pretty high. But once the 35% US statutory tax rate declines precipitously to 21%, it is very easy to argue that this required Income Tax Reserve as well as the additional amounts to cover audits can both be reduced from what they otherwise would be, which results in a lower effective income tax rate in 2018 and in subsequent years.
Also, after the Initial Toll Tax is all paid by US multi-nationals, the US tax exposure from subsequent foreign earnings repatriation goes away with the Trump Tax Cuts Act.
To put it simply, financial pundits who claim that purely domestic companies will get substantially more tax cuts than very creative US multi-national corps have it wrong. The Trump Tax Cuts Act gives these very creative US multi-national Corps even more reason to shift income to lower-taxed foreign countries. And what that also means is that the US CBO has substantially overestimated US Government Corporation US Federal Income Tax Revenues from the Trump Tax Cuts Act and has substantially underestimated the resultant US Deficit.
So yeah, a 6.4% drop in Alphabet's 1Q 2018 effective income tax rate seems very reasonable to me.
Further, to criticize Alphabet for tripling its Capital Investments in the 1Q 2018 is pure craziness, particularly if a good chunk of it is made in the US. Capital Investments are critical to the effectiveness of the key Web Services arena. And Alphabet increased its number of employees from 74,000 a year ago to 85,000 now, up 15%. So what do you want them to do, camp out on the lawn while they are working during the day? And they need some really good hard capital goods tools to work effectively. And The Bets area certainly need Capital Investments. Just saying.
