Alphabet Inc.

Good day, ladies and gentlemen, and welcome to the Alphabet fourth quarter 2018 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require operator assistance, please press star and then zero on your touchtone telephone. I'd now like to turn the conference over to Ellen West, Head of Investor Relations. Please go ahead.

Fourth Quarter 2018 Earnings Conference Call. With us today are Ruth Peratt and Sundar Pichai. Now I'll quickly cover the safe harbor. Some of the statements that we make today regarding our business performance and operations and our expected level of capital expenditures may be considered forward-looking, and such statements involve a number of risks and uncertainties that could cause actual results to differ materially. For more information, please refer to the risk factors discussed in our most recent Form 10-K, Thank you, Ellen.

We had a strong 2018 with total revenues of $136.8 billion, up 23% over 2017, reflecting the benefit of our ongoing investments to deliver exceptional experiences for users and compelling returns for our advertisers, partners, and enterprise customers. For the fourth quarter, revenues of $39.3 billion were up 22% year-on-year and up 23% in constant currency, as we continue to benefit from ongoing strength in mobile search with important contributions from YouTube, cloud, and desktop search. For today's call, I will begin with a review of results for the quarter on a consolidated basis for Alphabet, focusing on year-over-year changes. I will then review results for Google, followed by other bets, and will conclude with our outlook. Sundar will then discuss business and product highlights, after which we will take your questions. Let me start with a summary of Alphabet's consolidated financial performance for the quarter. Our total revenues of $39.3 billion reflect a negative currency impact year-over-year of $724 million, or $600 million after the impact of our hedging program. Turning to alphabet revenues by geography, you can see that our performance was strong again in all regions. U.S. revenues were $18.7 billion, up 21% year-over-year. EMEA revenues were $12.4 billion, up 20% year-over-year in both reported and constant currency terms, with a slight headwind primarily from the euro. APAC revenues were $6.1 billion, up 29% versus last year, and up 32% in constant currency, reflecting weakness of the Australian dollar. Other America's revenues were $2.2 billion, up 16% year-over-year, and up 26% in constant currency, reflecting weakening of the Brazilian real and the Argentine peso. On a consolidated basis, total cost of revenues, including TAC, which I will discuss in the Google segment results, was $17.9 billion, up 26% year-on-year. Other cost of revenues on a consolidated basis was $10.5 billion, up 34% year-over-year, primarily driven by Google-related expenses. The key drivers were first, content acquisition costs, primarily for YouTube, mostly for our advertising-supported content in what is a seasonally strong quarter for YouTube, but also for our newer subscription businesses, YouTube Premium and YouTube TV, which have higher CAC as a percentage of revenues. Second, costs associated with our data centers and other operations, including depreciation. And third, hardware-related costs for our Made by Google and Nest family of products. Operating expenses were $13.2 billion of 27% year-over-year. The biggest increase was in R&D expenses, with the larger driver being headcount growth, followed by the accrual of compensation expenses to reflect increases in the valuation of equity and certain other bets. Growth in sales and marketing expenses reflect increases in sales and marketing headcount, primarily for cloud and ads, followed by advertising investments, mainly in search and the assistant. The growth in G&A expenses reflects mostly increases in headcount. Stock-based compensation totaled $2.3 billion. Headcount at the end of the quarter was 98,771, up 4,399 from last quarter. Consistent with prior quarters, the majority of new hires were engineers and product managers. In terms of product areas, the most sizable headcount increases were were in cloud for both technical and sales roles. Operating income was $8.2 billion, up 7% versus last year, for an operating margin of 21%. Other income and expense was $1.9 billion, which includes $1.3 billion of unrealized gain related to a non-marketable debt security investment. We provide more detail on these line items within OINE in our earnings press release. Our effective tax rate was 11.2% for the fourth quarter, reflecting a discrete benefit due to the reversal of an accrual made as a result of updated guidance associated with the U.S. Tax Act. Net income was $8.9 billion, and earnings per diluted share were $12.77. Turning now to CapEx and operating cash flow. Cash CapEx for the quarter was $7.1 billion, which I will discuss in the Google segment results. Operating cash flow was $13 billion with free cash flow of $5.9 billion. We ended the quarter with cash and marketable securities of approximately $109 billion. Let me now turn to our segment financial results. Starting with the Google segment, revenues were $39.1 billion, up 22% year-over-year. In terms of the revenue detail, Google Sites revenues were $27 billion in the quarter, up 22% year-over-year. In terms of dollar growth, results were led again by mobile search, with a strong contribution from YouTube, followed by desktop search. Network revenues were $5.6 billion, up 12% year-on-year, reflecting the ongoing momentum of AdMob and Google Ad Manager. Other revenues for Google were $6.5 billion, up 31% year-over-year, fueled by cloud, hardware, and play. We continue to provide monetization metrics in our earnings press release to give you a sense of the price and volume dynamics of our advertising businesses. Total traffic acquisition costs were $7.4 billion, or 23% of total advertising revenues, and up 15% year over year. Total TAC, as a percentage of total advertising revenues, was down year over year, primarily reflecting a favorable revenue mix shift from network to sites. The increase in the site's TAC rate year over year was driven by the ongoing shift to mobile, which carries higher TAC, followed by changes in partner agreements, offset by the seasonally higher proportion of YouTube advertising revenues in the fourth quarter. In Q4, the network TAC rate declined year on year, primarily due to a revenue mix shift within our programmatic business. Google stock-based compensation totaled $2.1 billion for the quarter, up 22% year-over-year. Operating income was $9.7 billion, up 13% versus last year, and the operating margin was 24.8%. Accrued CapEx for the quarter was $6.8 billion, reflecting investments in office facilities, data centers, and servers. Let me now turn to and talk about other bets. I'll cover results for the full year 2018 because it remains most instructive to look at the financials for other bets over a longer-term horizon, as we have discussed on prior calls. Results for the quarter are in our earnings release. For the full year 2018, other bets revenues were $595 million, up 25% versus 2017, primarily generated by Fiber and Verily. Operating loss for other bets was $3.4 billion for the full year 2018 versus an operating loss of $2.7 billion in 2017. Other bets accrued CapEx was $181 million, down from $493 million in 2017, primarily reflecting investments in fiber. Key recent accomplishments include, in December 2017, Waymo launched Waymo One, which enables participants to use its app to hail and pay for rides. Also, Verily recently announced a $1 billion investment round led by Silver Lake as it advances on plans that are complementary and additive to its current life sciences portfolio. That investment, of course, was in addition to the $800 million it raised from Tomasic previously. Let me close with some observations on our priorities and longer-term outlook. First, with respect to revenues, our 23% revenue growth in 2018 was powered in particular by the ongoing benefit of innovation in our site's business. With eight products with more than 1 billion users each and more people coming online every day, we remain excited by the opportunities to continue to create valuable experiences for users around the globe. In particular, we see significant ongoing potential to apply our machine learning capabilities across our businesses. In our advertising business, machine learning has enabled innovation in advertisers' ability to match consumer intent and to bid more effectively for improved ROI. It has also enhanced the ability of smaller businesses to benefit from advertising on our platforms. Machine learning is also driving differentiation for newer Google businesses, like cloud and hardware. as well as central to a number of other bets, most notably Waymo and Verily. Looking ahead, a couple of things to note. First, as we've said many times, we continuously work to enhance the user and advertiser experience. Because we make changes with a focus on the best interest of users and advertisers over the long term, the timing of the introduction of new experiences, particularly in search advertising, can vary, which can result in an impact on quarterly year-on-year growth. Second, during 2018, the FX tailwinds in the first half of the year turned to headwinds in the third and fourth quarters, in line with the strengthening of the U.S. dollar. Based on the continuing strengthening of the U.S. dollar, we expect a headwind to reported versus fixed FX results in the first quarter in contrast to the favorable impact of FX in the first quarter of 2018. Turning to Investments and Profitability In terms of gross margin, the biggest component within cost of revenues remains our traffic acquisition costs, reflecting our strong revenue growth in mobile search and the fact that mobile search carries higher TAC than our desktop business. As we've discussed on prior calls, while the pace of year-on-year growth in sites TAC as a percentage of sites revenues slowed after the first quarter of 2018, we do expect the sites TAC rate to continue to increase year-on-year, reflecting ongoing strength in mobile search. Within OpEx, we remain focused on prioritization in order to optimize resources for longer-term growth in sizable markets. You'll see us continue to support our priority areas with increased headcount, which will remain concentrated in R&D, although we expect the growth rate to moderate in 2019. In 2018, we also saw continued progress on our goal to nurture new businesses outside of Google, our other bets, with a model of independence. While I've said previously that there is no monolithic approach to how the other bets execute against opportunities, a shared principle is aligning employee interests with the long-term value creation by these companies. Since inception, this has been an important part of our approach at Google, with stock grants comprising a meaningful component of overall compensation across our employee base. We're increasingly following that approach in the other bets, with compensation programs that align employee and company interests. You've seen the impact of some of those programs in the fourth quarter as we accrued compensation expenses to reflect increases in the valuation of equity in certain other bets. While these expenses will recur, the timing of valuation events is unpredictable and can vary between bets, which can affect quarterly comparisons. Finally, on capital allocation, our primary use continues to be to support organic growth in our businesses, followed by retaining flexibility for acquisitions. After taking these needs into account, our board has authorized the repurchase of up to an additional $12.5 billion of our Class C capital stock. With respect to CapEx, we continue to invest in both compute requirements and for office facilities, although we expect the CapEx growth rate in 2019 to moderate quite significantly. Inclusion 2018 was another great year with tremendous ongoing opportunity ahead of us. I will now turn the call over to Sundar.