How to read and analyze an income statement?
This video is a sequel to "How to read an annual report", and covers the 2017 income
statement of Alphabet Inc, the parent company of Google and other bets.
There are many interesting things to learn about Alphabet Inc and its business model.
The income statement is a great starting point for that learning journey.
This video is for educational purposes only, none of the comments in this video should
be interpreted as investment advice.
I am not a shareholder of Alphabet Inc.
As the video is for educational purposes, please do try this at home!
I am very interested to hear your comments and suggestions,
please post them below the video.
In order to analyze an income statement, you need to download the company's annual report.
In the case of Alphabet Inc, go to abc.xyz/investor, go to the column with the full year numbers,
and download the 10-K PDF version.
This document is 105 pages long.
Scroll down the table of contents of the 10-K annual report, up to item 8: financial statements
and supplementary data.
Click on the link.
You now arrive at the index to the financial statements, and the related notes.
Click on "consolidated statements of income".
This is the income statement of Alphabet Inc for 2017.
On purpose, I first take only the numbers of the latest year,
to set priorities for the analysis.
Going down the income statement from top to bottom, the first thing that jumps out is
the revenue of more than $110 billion.
Second item: margins, how do operating income and net income compare to revenue.
Third item is an unusual one: European Commission fine of $2.7 billion.
What is behind that, and what are the implications going forward?
Fourth item, other income which in the case of Alphabet Inc is a positive contributor.
Fifth item: the provision for corporate income taxes.
This looks unusually high at more than half of the earnings before taxes.
Now that we have compiled the "To Do" list of five key items, let's look at the latest
three years of Alphabet Inc's income statement.
We see very strong revenue growth of more than 20%, two years in a row.
Income from Operations is not growing at the same rate as revenue in 2017, let's look
into that in more detail, probably the European Commission fine is an important driver.
Net income in 2017 is lower than net income in 2016, with the provision for income taxes
being around $10 billion higher.
This three year look at the income statement confirms the "To Do" list: revenue, margins,
European Commission fine, other income, and taxes.
So let's get started!
You can read the whole 105 pages of the annual report from start to finish, which would take
you a while to complete, or use the search function in Adobe Acrobat Reader.
Use the key combination CTRL+F to bring up the dialog box, type in the search term, and
use that to browse through the document.
If you want to do your own research first, this would be a great place to pause the video,
and come back to watch the rest of the video to compare your notes and my notes.
First up is revenue.
Let's have that number of $110.9 billion sink in.
1 1 0 8 5 5 0 0 0 0 0 0.
That's 23% higher than the year before.
On page 56 of the annual report, Alphabet Inc discusses the nature of operations in note 1:
"We generate revenues primarily by delivering relevant, cost-effective online advertising."
The risk factors on page 10 specify that 86% of total revenues were generated from advertising
in 2017.
Page 31 has the revenue by segment.
There's the $110.9 billion again at the bottom, of which 99% is generated by the Google segment,
and 1% by other bets.
Other bets are early-stage businesses, some of which you may have heard of: examples are
Nest, Verily and Waymo.
The revenue generated by the businesses in the other bets segment is not substantial
yet, but could become so in the medium to long term.
Within the Google segment, revenues are split between advertising revenues and other revenues.
Other revenues consist primarily of revenues from apps, in-app purchases, and digital content
in the Google Play store; Google Cloud offerings; and hardware.
Advertising revenue is split between revenue from Google properties (such as Google.com
searches, Gmail, Google Maps, Google Play, YouTube), and revenue from Google Network
Members' properties (clicks and impressions of advertisements served by Google on websites
owned by network members).
Unfortunately, there is no further breakdown of the revenue or the margins on the level
of individual Google products.
Personally, I would find it very interesting to learn what the revenue and margin specifically
for YouTube are, but alas, that information is not available to the public.
On page 35, we find the revenues by geography.
47% of Alphabet Inc's total revenue is US-based, and 53% non-US based.
Now that we have taken a good look at revenues, it's time to review the margins that Alphabet
Inc makes on those revenues.
Before we fire up our calculators, it's good to synchronize our understanding of some acronyms.
GM% is Gross Margin % which is calculated by taking Gross Margin and dividing it by Revenue.
OM% is Operating Margin % which is calculated by taking Operating Income and dividing it by Revenue.
ROS% is Return On Sales % which is calculated by taking Net Income and dividing it by Revenue.
Industry or company-specific acronyms are CAC Content acquisition costs,
and TAC Traffic acquisition costs.
In order to review margins over the three years in the scope of our research, I thought
it would be easiest to use Excel for the calculations.
So here's that overview on the screen.
Gross Margin is around 60%, with a slightly downward trend.
Research and Development expenses are 15% of revenue, which is around what I would expect
for a technology company.
Sales and Marketing expenses are 12% of revenue, in other words Sales and Marketing expense $
are growing in line with revenue $ therefore the % stays the same, and General and Administrative
expenses are going down from 8% to 6%.
This adds up to a total SG&A percentage of 18%, which seems to be right in line with
the median across a range of industries.
The European Commission fine in 2017 amounts to 2% of revenue,
which explains why Operating Margin % is 24% of revenue
rather than the 26% in previous years.
The Gross Margin % of 60% and Operating Margin % of 26% are key numbers to remember for Alphabet Inc.
These are two financial indicators that can provide meaningful comparisons between companies.
The Return On Sales % in 2017 is 11%, versus 22% in previous years.
We will find the driver for that when we review taxes.
So how do the margins at Alphabet Inc compare to another well-known technology company, Facebook?
Facebook's revenue is $40.7 billion, compared to Alphabet Inc's $110.9 billion.
On those revenues, Alphabet Inc makes around 60% gross margin and Facebook 87%, as Facebook
has much lower cost of revenues.
Around 27 to 28%-points difference in gross margin, which translates to about the same
difference in operating margin %-points.
Alphabet Inc spends more in R&D in absolute $ terms,
Facebook spends more in relative % terms.
On SG&A, both companies spend 18%.
We are not going to replicate the full analysis we are doing on the Alphabet Inc income statement
right here and right now on the Facebook income statement, but we could look into the drivers
of cost of revenues (and the resulting gross margins) for Alphabet Inc, as that is such
a major element of total expenses.
Cost of revenues is discussed on page 38.
The $45.6 billion in 2017 is split between Traffic Acquisition Costs of $21.7 billion,
and other cost of revenues of $23.9 billion.
Other cost of revenues consists of content acquisition costs, data center and other operations
costs, including depreciation, compensation expenses, energy, bandwidth, and other equipment
costs, cost of sales of hardware devices, etc.
Traffic Acquisition Costs are split between TAC to distribution partners (for example
websites and apps that use google.com as the default search in browsers and toolbars),
and TAC to Google Network members.
The payout rate for Google Network members (websites that run advertisements served by
Google) is actually 72%, meaning that Google gets to keep only 28% of that revenue.
So that's a very different business than the 60+% margins on Google properties revenues.
Revenues and margins analysis done, two very big topics.
Onward to the next item on the list: the European Commission fine.
The European Commission investigations are discussed in the "Legal Matters" section on page 77.
In 2010, the European Commission opened an investigation into various antitrust-related complaints.
In 2017, the EC announced its decision that certain actions taken by Google regarding
its display and ranking of shopping search results and ads infringed European competition
law, and imposed a fine of $2.7 billion.
Google is appealing the EU decision, but did have to implement product changes to bring
shopping ads into compliance with the EC's decision.
So not only is this a very significant fine, it also changes the way Google operates going
forward, and might impact future revenues and future margins.
There are other EC investigations in progress, with uncertain outcomes.
Next item on the list: other income.
This is a contributor to profitability for Alphabet Inc.
On page 74, we find that the main element of other income is the interest income that
Alphabet Inc generates on its portfolio of cash, cash equivalents and marketable securities.
How big that portfolio is, will be one of the items for research on the balance sheet analysis!
Next item: the provision for income taxes.
The pattern in 2017 is unusual here, with the provision for income taxes relative to
the income before income taxes, being relatively high.
Page 84 provides an overview of the effective tax rate over the years:
17% in 2015, 19% in 2016, and 54% in 2017.
The unusually high rate of 54% in 2017 is driven by the impact of the Tax Act, with
the effect of the one-time transition tax amounting to 38% of income before income taxes.
Due to the timing of the enactment and the complexity involved in applying the provisions
of the Tax Act, the effect on the expected effective tax rate for 2018 is as yet unknown.
This will be an interesting item to keep an eye on during the 2018 quarterly earnings
releases, and the 2018 annual report.
We have succeeded in performing a high-level income statement analysis of Alphabet Inc
for 2017, by focusing on five areas: revenue, margins, European Commission fine, other income, and taxes.
As the video is for educational purposes, please do try this at home!
Which observations did you come up with?
Are there any items missing in this analysis?
I am very interested to hear your comments, please post them below the video.
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