🔎 Alphabet: All Roads Lead To AI
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🔎 Alphabet: All Roads Lead To AI
Growth accelerates and CFO Ruth Porat gets a promotion
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Alphabet just reported its Q2 FY23 earnings.
“With 15 products that each serve 0.5 billion people and 6 that serve over 2 billion each, we have so many opportunities to deliver on our mission.”
CEO Sundar Pichai reminded us that incorporating AI in Alphabet’s products impacts billions of people. From Gmail to Photos to Android OS, all roads lead to AI.
The company saw its fastest revenue growth since Q2 FY22. The resilience of Search advertising and a strong showing from YouTube and Cloud caught the market’s attention.
Today, we’ll cover the following:
Alphabet Q2 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
1. Alphabet Q2 FY23
Income statement:
Here is a bird’s-eye view of the income statement.
Revenue by segment (growth Y/Y):
Advertising: $58.1 billion (+3%).
Search: $42.6 billion (+5%).
YouTube ads: $7.7 billion (+4%).
Network: $7.9 billion (-5%).
Other (Play, Hardware, Subscriptions): $8.1 billion (+24%).
Cloud: $8.0 billion (+28%, no decelerarion).
Other Bets were $0.3 billion.
Main highlights:
Revenue grew +7% Y/Y to $74.6 billion or +9% fx neutral (a $1.8 billion beat).
Gross margin was 57% (flat Y/Y).
Operating margin was 29% (+1pp Y/Y).
Services (Advertising & Other) was 35% (+1pp Y/Y).
Cloud was 5% (+14pp Y/Y, +2pp Q/Q).
Earnings per share $1.44 ($0.10 beat).
Cash flow:
Operating cash flow was $28.7 billion (38% margin, +10pp Y/Y).
Free cash flow was $21.8 billion (29% margin, +11pp Y/Y).
Balance sheet:
Cash, cash equivalent, and marketable securities: $118.3 billion.
Long-term debt: $13.7 billion.
So what to make of all this?
The growth in constant currency was +9% Y/Y and is a better representation of the business performance.
Advertising revenue growth accelerated to +3% Y/Y after being flat in Q1:
Search grew +5% Y/Y, led by growth in retail.
YouTube grew +4% Y/Y, driven by brand advertising (more on that in a minute), after an annual decline in the past two quarters.
Other (Subscriptions, Play, Hardware) grew +24% Y/Y, a significant acceleration from +9% Y/Y in Q1. YouTube subscriptions (Music, Premium, TV) saw strong growth (no exact number provided). Hardware was also a positive factor, with the Pixel 7a released in Q2 FY23, while the Pixel 6a launched in Q3 FY22. This tailwind will turn into a headwind next quarter. Play returned to positive growth.
Cloud remained the fastest-growing segment, +28% Y/Y (no slowdown).
After five quarters of profit decline, Q2 was a nice rebound, explained by the recent layoffs and office space reductions in Q1. The company also benefited from a $1.0 billion positive impact from adjusting depreciation expenses (a change in the estimated useful life of servers we discussed last quarter).
Stock buybacks were $15 billion in Q2, maintaining the same pace as the past few quarters. So management still saw shares as attractive.
CFO Ruth Porat will transition to President and Chief Investment Officer in September. She will oversee the Other Bets portfolio.
2. Recent business highlights
YouTube is leading the pack
YouTube ads are making a comeback after two consecutive quarters of negative growth. To put this in context, YouTube ads accounted for 94% of Netflix's revenue in Q2, a rise from 91% the previous year. Below is a chart comparing YouTube ad revenue to Netflix. YouTube Premium revenue is not available, hence missing from the chart.
Advertising is more volatile and seasonal than a premium subscription service like Netflix. Ads still have a minimal impact on Netflix’s overall revenue, as discussed in our coverage of the company’s earnings earlier this week. This could change as Netflix phases out the basic ad-free plan and raises prices for its premium plans.
Management called out brand marketing as the main factor behind the recent YouTube rebound ahead of direct response.
For the marketing newbies:
Brand marketing aims to build and enhance a brand's image over time, prioritizing long-term goals like awareness and positive brand perception. It's more about establishing a brand's presence and values in the audience's mind, often through channels such as TV ads, billboards, and digital media.
Conversely, direct response marketing urges immediate action from the audience, such as a purchase or sign-up. Success is measured by conversion rate and campaigns often feature a clear call-to-action (CTA). This measurable form of advertising often uses channels like email marketing and pay-per-click ads.
Brand marketing as a tailwind indicates that YouTube is incrementally capturing market share from traditional TV. As more viewers shift away from cable, YouTube is well-positioned to offer brands an equivalent reach.
YouTube’s first-party data, which comes directly from users' interaction with the platform, enables advertisers to target their ads with exceptional precision. According to measurement firms Nielsen, TransUnion, and Ipsos MMA, YouTube delivers a higher Return on Investment (ROI) than TV and other online video platforms.
Philip Schindler, Chief Business Officer, highlighted The Hershey Company during the call. Hershey regards YouTube as its top ROI-driving media partner. This is especially noteworthy considering Netflix’s current challenges in reaching advertisers due to the small portion of subscribers on the ad-supported tier.
YouTube ads make up 10% of Alphabet’s overall revenue. But remember, premium subscriptions like YouTube Premium, Music, and TV are included with Play in the “Other” category. So YouTube’s overall share of revenue is likely closer to 15%.
Management has prioritized growth in YouTube Shorts (short vertical videos on YouTube, similar to TikTok), Connected TV, and subscription offerings:
YouTube Shorts are now watched by over 2 billion logged-in users a month, up from 1.5 billion a year ago. Shorts are still relatively new and under-monetized (like Reels for Meta).
YouTube is leading all streaming platforms in the share of US TV time, reaching an 8.8% market share in June 2023 (excluding YouTube TV). That compares to 7.8% last quarter. The platform reaches over 150 million people on connected TV screens in the US.
YouTube Premium and Music increased in price in July (by 17% and 10%, respectively). It’s the first increase since 2018. These services surpassed 80 million subscribers in Q1 (including triallers). We don’t have exact numbers, but it’s safe to say there is nearly $3 billion in revenue from these subscriptions quarterly. This puts YouTube’s overall revenue well ahead of Netflix and close to $40 billion annually.
YouTube TV also increased its price in the US to $73 per month in March (a 12% increase). With Primetime Channels and the NFL Sunday Ticket offering, YouTube effectively offers the ultimate TV bundle for cord-cutters.
Cloud: a fast grower with expanding margins
Cloud grew by +28% Y/Y in Q2 FY23, with no deceleration from Q1 FY23.
So how good is this? It slightly outpaced Azure (+27% Y/Y in constant currency, a slowdown from +31% Y/Y in Q1). Watch for AWS's growth numbers when Amazon reports next week (+10% Y/Y expected). Remember, Google Cloud includes GCP (Google Cloud Platform) and Google Workspace, making a direct comparison with AWS or Azure slightly complicated. Management reiterated that GCP growth is faster than Google Cloud.
AI is a significant growth driver for Cloud. The company sees AI as an opportunity to upsell and cross-sell to its existing user base. The AI-powered assistant, Duet AI, will be released later this year. It will tap into a pool of over 9 million paying Workspace customers. There is no official pricing yet, but Microsoft may have set the tone with Microsoft 365 Copilot charging $30 per user per month. For now, 750,000 Workspace users have access to Duet AI in preview. Management also sees opportunities in cybersecurity.
Cloud expanded its operating margin from 3% to 5% sequentially.
3. Key quotes from the earnings call
CEO Sundar Pichai talked about the four ways to make AI helpful for everyone:
Improving knowledge and learning (integrating AI in Search products).
Helping people use AI to boost their creativity (Bard, Lens, Duet AI).
Making it easier for others to innovate using AI (Cloud AI models).
Developing and deploying AI technology responsibly (principles and efficiency).
On the launch of the Search Generative Experience (SGE):
“User feedback has been very positive so far. It can better answer the queries people come to us with today, while also unlocking entirely new types of questions that Search can answer.”
SGE signals Alphabet's continued efforts to innovate and remain a leader in the search category (57% of revenue). So it’s the biggest needle mover.
On the recent reorganization to focus on AI:
“Products like Bard and SGE are being built by small fast-moving teams that have been reallocated to these high-priority efforts. Overall, we are actively moving people to higher priority activities within the Company, and we continue to optimize our real estate footprint for current and future needs.”
The reorganization is reminiscent of Meta’s “year of efficiency,” with less staff involved in new innovations to move faster.
On GCP market share:
“More than 70% of gen AI unicorns are Google Cloud customers, including Cohere, Jasper, Typeface and many more. We provide the widest choice of AI supercomputer options with Google TPUs and advanced NVIDIA GPUs, and recently launched new A3 AI supercomputers powered by NVIDIA's H100.”
On Ruth Porat’s transition:
“As our longest-serving CFO, she has helped guide the company through an amazing period of growth, a global pandemic and the ongoing economic uncertainty that has followed. I'm excited to continue to work with Ruth, who will lead our 2024 planning and remain as CFO while we do a full search for a successor.”
Chief Business Officer Philipp Schindler touched on AI and ads:
“We launched a new conversational experience in Google Ads powered by a LLM tuned specifically from ads data to make campaign construction easier than ever. Advertisers also tell us they want help creating high-quality ads that work in an instant. So, we're rolling out a revamped asset creation flow in Performance Max that helps customers adapt and scale their most successful creative concepts in a few clicks. […] Later this year, automatically created assets, which are already generating headlines and descriptions for search ads, will start using generative AI to create assets that are even more relevant to customer queries.”
Alphabet is integrating AI into its advertising platform, aiming to optimize creation, performance, and insights. This is critical to keeping advertisers in its ecosystem.
CFO Ruth Porat on headcounts and efficiencies:
“We continue to moderate the pace of fit-outs and ground-up construction to reflect the slower expected pace of headcount growth. […] We expect elevated levels of investment in our technical infrastructure increasing through the back half of 2023 and continuing to grow in 2024.”
Integrating AI everywhere won’t be cheap. While capital expenditures didn’t increase as much as expected in Q2 due to some delays in data center construction projects, we can expect them to increase gradually.
4. What to watch looking forward
Search Generative Experience (SGE)
The new SGE feature utilizes AI to create more comprehensive and informative summaries of search results, enhancing the traditional list of links. As the feature is still in development, it will be worth monitoring its rollout and user reception. It can potentially be a significant improvement over the traditional search experience.
Cloud Next 2023 in August
Expect a flurry of announcements at the upcoming Cloud Next event, focusing on AI, security, and management tools.
Keep an eye out for:
Innovations in AI that streamline tasks and bolster decision-making processes.
Enhanced security features designed to protect business data better.
Efficient management tools for improved application deployment on GCP.
Partnerships aimed at reaching new customers and growing market share.
Is Microsoft stealing market share in Search?
The short answer is no.
Despite Microsoft's Bing new features powered by ChatGPT, Google continues to hold an unchanged 93% share of the global search market as of June 2023. Bing remains a distant second with a less than 3% global market share.
According to Statcounter, Bing's US market share was 6.5% in June 2023, slightly down from 6.6% in March 2023.
During Microsoft's earnings call, Satya Nadella did not mention any progress in Bing’s market share this time around, something he had hinted at in the previous call. So far, it doesn’t look like Bing is gaining market share in this category, but it’s critical to watch.
The real competitive pressure may not be felt on the top line for now.
But it will certainly amp up the pressure on CapEx for the foreseeable future.
We have more special reports coming up, each focusing on a unique theme within the tech industry. We'd love to hear from you.
Which topic would you like us to dive into first?
That’s it for today!
Stay healthy and invest on!
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Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
Disclosure: I am long GOOG in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
🔎 Alphabet: All Roads Lead To AI
Nice earnings summary and writeup!! Thoroughly enjoyed..