Introduction
We first wrote about Alphabet/ Google on 5 May 2023. In that initial note, we highlighted the remarkable three-decade story of this company. We noted the dominance of their Search and Advertising business.
GOOGL has been a remarkable cash generating machine and the huge Search and Advertising cash flow had been used to diversify the business. The use of this cash included acquisitions (notably YouTube, Doubleclick and DeepMind), Investments (most notably the Cloud business, GCP) and new projects or moonshots (e.g. Waymo and Verily). The excess cash has also been used to recruit heavily and pay employees very generously.
At the time of writing the note in May 2023, we were worried about then widely forecast US recession and its impact on advertising spend and about the high remuneration at GOOGL.
The US economy seems to have avoided a recession and Google has started to cut its bloated labour force in earnest.
The Latest Quarterly Results
Alphabet reported its fourth quarter earnings on Tuesday, missing analysts' expectations in the dominant advertising revenue segment.
The key elements were as follows:
Revenue, excluding traffic acquisition costs, was $72.3 bn vs. expectations of $71.0 bn.
Adjusted EPS was $1.64 vs. expectations of $1.59.
Cloud revenue: $9.19 bn vs. expectations of $8.95bn
Advertising revenue: $65.5 bn vs. expectations of $65.8 bn.
Source: MBI Deep dives
Total advertising revenue grew 11.0% to US$ 65.5bn. The company is still heavily dependent on Search, where revenue was US$ 48bn and is 55% of total revenues.
Growth in Search (+12.7%) and YouTube Ads (+15.5%) was offset by a 2.1% decline in Google Network.
Cloud revenue was US$ 9.1.bn (+25.7%) and was 1.7% better than expected.
Google Cloud revenues grew 25.7% year-on-year, while its EBIT has tripled sequentially from $266m to $864m.
Margins
Source: MBI Deep Dives
Overall Operating Margin was 27.5%. Within this, Services Operating Margin was 35.0% compared with 29% in the same quarter last year. Cloud Operating Margin was 9.4%. compared with -2.5% in the same quarter last year.
EBIT margin has expanded because of good cost control. The number of employees is down 4% year-on-year as of Q4 2023. Google Services EBIT Margin has expanded by more than 5 percentage points year-on-year from 29.8% to 35.0%.
In Cloud, Google is working hard to catch up with Amazon and Microsoft by investing heavily. The recovery in Cloud margins has been impressive. In the last five quarters, Cloud Margin has risen from -2.5% to 9.4%.
Source: MBI Deep Dives
In the medium term, Cloud is likely to be a much larger and a much higher margin business. It is likely to boost GOOGL’s overall margins significantly.
Q4 Earnings
For Q4 there was:
30.5% growth in EBIT,
51.8% growth in Net Income and
56.0% growth in EPS:
Q4 EBIT growth was distorted by three one-off items. If one adjusts for this, EBIT growth was 23.5%. This is high and comfortably ahead of revenue growth. A 56% growth in EPS indicates the company continues to demonstrate operating leverage.
For full-year 2023,
Revenue growth was 8.7%
EBIT Growth was 12.6%
Net Income Growth was 23.0%
EPS growth was 27.3%.
This again indicates operating leverage as the full year topline growth of 8.7% translates to EPS growth of 27.3%.
Highlights from the Conference Call
As was the case in the Microsoft, AI was a key theme on the earnings conference call.
Google has a developed a series of foundational AI models under the “Gemini” umbrella that are being used across its entire product suite.
They have not moved as quickly in monetising Gemini as Microsoft has with Copilot,
They offer “Vertex AI” which will allow developers to create Generative AI apps.
Usage of Vertex’s APIs has increased 600% Y/Y.
AI is also being applied to Search in the form of two Gemini products which are Search Generative Experience (SGE) and Bard
SGE uses Generative AI to enhance search result quality while Bard is more conversational. SGE has reduced speed response times by 40%.
“We're already experimenting with Gemini (a family of Large Language Models) in Search where it's making our Search Generative Experience, or SGE, faster for users. We have seen a 40% reduction in latency in English in the U.S. … By applying generative AI to Search, we are able to serve a wider range of information needs and answer new types of questions … We are improving satisfaction including answers for more conversational and intricate queries … We are surfacing more links with SGE and linking to a wider range of sources on the results page."
The application of Generative AI and Advertising.
Gemini is being used to accelerate advertising campaign content creation which will allows ad buyers to generate more relevant results to improve conversion.
Gemini is also being utilised in its Performance Max (PMax) campaign service. PMax is a tool that aggregates Google and 3rd party impressions for advertisers to choose from. PMax has been shown to raise conversion for advertisers by 18%.
Subscription businesses
Subscriptions business now has revenues of $15 bn per annum. Google One which allows additional Cloud Storage to consumers has crossed 100 million subscribers. YouTube TV Premium and YouTube Music are also growing strongly though these are a low-margin businesses.
Google Cloud
Google emphasised the sequential acceleration in growth in Cloud as well as the resumption in sequential operating leverage.
AI is also boosting growth in Cloud. Google Cloud Platform (GCP) deepened McDonald’s and Verizon relationships during the quarter with AI product add-ons. Like Microsoft, Google also noted that the period of optimisation and consolidation of workload migration to the Cloud is over, and demand should increase going forward.
The Cloud growth of 25.7% compares with the 30% reported by Microsoft for the same period.
Retrenchment
The conference call also gave an update on cost cutting and job cuts.
Google said they are “pleased with the progress” they are making in “re-engineering the cost base.” The company said they will continue to hire only engineering and other technical talent. Middle management layers will continue to be removed.
The CFO disclosed that severance-related expense will be roughly $700m in Q1 2024 (compared to $2.1bn for the whole of 2023), which indicates a significant headcount reduction in the current quarter.
Our Comments
This was a good set of results.
There was a slight miss in advertising revenues, but this should not be too concerning.
The strong performance in the Cloud business in terms of revenue growth (+25.7%) and margins was very impressive. Google is succeeding in its ambition to catch up with Microsoft and Amazon. In the medium term, Cloud will be significant business along with Search and YouTube.
The company’s model continues to demonstrate a high degree of operating leverage.
The company seems to be making serious progress in cutting costs.
On the negative side, the need to invest for AI and cloud, the company will have to increase capital expenditure significantly. This will negatively impact free cash flow generation, at least in the short run.
Google is behind Microsoft in implementing AI and developing related products and services.
Valuation
Alphabet generated $69.5bn of Free Cash Flow (FCF) in 2023. If one adjusts for Share-Based Compensation (SBC) costs and related payments, FCF was $36.7bn in 2023. An FCF of $37bn implies a FCF Yield of 2%. which look expensive and should normally be a red light to investors. However, in this case FCF is reduce due to the high capex run rate ($ 32bn per annum). In a few years this elevated capex is likely to fall back by about $10bn and boost future FCF by a similar amount.
In this case therefore earnings yield rather than FCF yield is currently a better metric for evaluating the company. The Earnings yield is 5% which implies a P/E ratio of 20 times.
Conclusion
We wrote our last note on Alphabet on 28th July 2023 and it can be seen here.
Our conclusion then was as follows:
The company continues to be a strong generator of profits and free cash flow.
Cost cutting will ensure the profits will grow faster.
AI will require significant additional investments but should ensure higher future profits and free cash flows in the medium to long term.
The current forward P/E multiple of 21 times looks attractive given likely 22%-25% ne profit growth, 25% operating margin and about 24% ROE.
We had an underweight position in GOOGL and would look to add to it at the current price.
The price of GOOGL at that time was $ 137 per share. It is currently only slightly higher at $ 141 per share.
Our view is little changed:
The company is likely to grow EPS in the next few years at 19% + at a Return on Equity (ROE) of about 25%-27%. Given the company’s strength in Search and growing progress in the Cloud, a P/E ratio of 20 times seems a reasonable valuation.
We prefer Microsoft for AI and Cloud but will allocate a smaller weight to an investment in Alphabet at current levels.
We were disappointed by the market sell off after these numbers due to a small miss on advertising numbers. However, this has provided us with an opportunity to buy at a lower price and a more attractive valuation.