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Alphabet’s Rising Costs Spark Worry About Shrinking Margins

Initially investors celebrated a robust quarter from Alphabet Inc., driven by strong sales growth. Then they spotted a red flag: rising costs that could crimp margins going forward.

The Google division generated most of the quarter’s revenue but paid out 22 percent of its $22.67 billion in sales in so-called traffic acquisition costs or TAC — payments to partners that direct traffic to its online properties and ads. A year ago, those costs represented 21 percent of Google’s sales.

“Growth in TAC accelerated for the third straight quarter, suggesting rising costs of future ad dollars,” said James Cakmak, an analyst at Monness Crespi Hardt & Co.

Shares of the Mountain View, California-based company fell 2.8 percent to $969.98 at 9:30 a.m. in New York. They gained 26 percent this year through Monday.

Most of Google’s growth comes from mobile search ads, YouTube marketing spots and automated marketing called programmatic campaigns. The company has to share more of the money from those ads than it does with its original web search marketing slots.

TAC payouts primarily go to network websites and mobile partners. Distribution partners, such as mobile carriers and handset-makers like Apple Inc., brought in more than 10 percent of Google’s revenue on its own properties. Other companies that use Google’s expansive ad tech systems took higher partnership payments. Pivotal Research Group analyst Brian Wieser attributed the rising costs to demands from marketers for better quality video ads.

Chief Financial Officer Ruth Porat said the company expects TAC for Google properties such as Search and YouTube to continue to increase, suggesting margins may shrink. She said the company is focusing on increasing total profits, rather than growing profit margins.

Despite rising costs, revenue was still in line with analysts’ consensus forecasts. “While growth was slightly below some expectations and margins declined year-over-year, growth was still strong on a large base, earnings per share exceeded expectations, and commentary about new opportunities suggest continued high growth and progress,” Citigroup Inc. analyst Mark May said in a note, maintaining a buy rating.

A record antitrust fine from the European Union hurt profit. The company accounted for the levy as a one-time dent, bringing net income to $5.01 per share. Analysts were expecting $4.45 per share, including the EU fine, according to figures compiled by Bloomberg.

Regulators there levied a $2.7 billion penalty in June, saying Google skewed its general search results to thwart smaller shopping search services. Alphabet disagreed and is considering an appeal. Two more antitrust probes against Google sit on the EU docket, a concern for some analysts worried about the impact of any forced changes to Google’s business.

Spending on Alphabet’s “Other Bets” fell sharply during the quarter. Porat attributed this to an ongoing retreat in the expansion of its Google Fiber fast internet service.

Still, spending on Google’s businesses increased. In particular, the company has plowed money into its cloud-computing business, which Porat said was one of the fastest-growing divisions. Google said it won three times as many cloud deals exceeding $500,000 as it did last year. That was the most the company has disclosed about its cloud sales to date.