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Tech giants’ profits pack less punch as margins shrink

Traders and financial professionals work on the floor of the New York Stock Exchange (NYSE) ahead of the closing bell, Aug. 2, 2017.

Drew Angerer/Getty Images

Investors love Big Tech right now for the combination of growth, competitive "moats" and fat profit margins. But would their feelings be so strong if tech giants' margins lose a little plump?

One theme in recent earnings from Apple, Google, Amazon and Facebook was rising costs from changes in strategy or the hunt for their next big businesses. This could be savvy investing in the future. But all four are at or near record stock prices, and investors may be disappointed if they're betting on current levels of profitability persisting.

Consider Apple. The stock touched an all-time high on Wednesday on the heels of strong results. Apple Inc. executives are enthusiastic about prospects for its newest products, and the company continues to swim in profit like few others. But Apple is getting a bit less flush.

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In its most recent quarter, operating profit as a share of revenue was the lowest in nine years because Apple is splurging more than ever in areas like research and development. Apple's operating expenses in the last 12 months were nearly 12 per cent of revenue, the highest percentage in seven years, Bloomberg data show.

CEO Tim Cook has deflected previous questions about what exactly Apple is spending money on, but he did tell analysts Tuesday that the company is "making a big investment" in technology for autonomous systems including driverless cars. That project and whatever else is brewing in Apple's secret laboratories could be the next big things. Or not. Either way, shareholders are picking up the check now for investments that may not pay off for years.

At Amazon, shares fell last week after investors realized (belatedly) that profits aren't going to suddenly rain from the company's Seattle headquarters. Spending on things like merchandise warehouses, web video programming and computer data centers slimmed its operating profit margin to a tiny 1.7 percent.

The spending is even more flush than it appears. Unlike its peers, Amazon.com Inc. also expands its warehouses and data centers through capital leases, and when those costs are included, Amazon's free cash flow was just $1.5-billion in the last 12 months. That means out of every $1 in cash coming into Amazon, it's left with 1 cent after accounting for all its cash expenses. That's not much.

Amazon hasn't said much about its pending acquisition of Whole Foods, but it's safe to guess that will require a spending splurge, too. It isn't cheap to fulfill the boundless ambitions of CEO Jeff Bezos. After the earnings report, Wall Street scaled back its expectations of Amazon's profits for the next couple of years.

Facebook and Google tend to have high profit margins, but even their businesses are shifting in ways that change this. Google's parent company Alphabet Inc. is handing over growing chunks of its revenue to partners like the companies that make YouTube videos and owners of web browsers such as Apple that provide portals for Google searches.

Google in the second quarter handed over more than 22 per cent of its revenue to these partners, the highest share since 2014. Of course, Google's revenue is growing quickly from ads in YouTube videos and mobile searches, but that still means each dollar of future sales comes with thinner margins. Its profit margin in the first half of this year was 26.5 per cent, compared with 31 per cent in 2011.

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Facebook's mission to become a TV-like destination will squash its margins, too. For now, the company pays basically nothing to keep users hooked on baby photos and posts about Donald Trump. That's changing. As Google did, Facebook Inc. is planning to share more revenue with companies that agree to make videos for its news feed.

Video ads "almost certainly will be a lower margin source of revenue than the current thing that we do," Facebook CEO Mark Zuckerberg told analysts last week. And costs to start TV-like programs on Facebook are also hitting the company's pocketbook this year.

These companies' absolute profits are all still climbing, and that may matter more to investors than their margins. Still, I'm not sure investors have come to grips with the possibility that Big Tech may have permanently lower-margin futures.

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Shira Ovide is a Bloomberg Gadfly columnist covering technology. She previously was a reporter for the Wall Street Journal.

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