🔎 Alphabet: Cloud Overshadows Ad Rebound
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🔎 Alphabet: Cloud Overshadows Ad Rebound
Search & YouTube reaccelerate but Cloud comes short
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Despite beating expectations with a rebound in advertising revenue, Alphabet’s stock tumbled nearly 10% after Tuesday’s earnings report.
Why? In short, the Cloud segment's slowdown didn't sit well with investors, especially when contrasted with Microsoft's cloud growth on the same day.
Today at a glance:
Alphabet Q3 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
1. Alphabet Q3 FY23
Income statement:
Here is a bird’s-eye view of the income statement.
Revenue by segment (growth Y/Y):
Advertising: $59.6 billion (+9%).
Search: $44.0 billion (+11%).
YouTube ads: $8.0 billion (+12%).
Network: $7.7 billion (-3%).
Other (Play, Hardware, Subscriptions): $8.3 billion (+21%).
Cloud: $8.4 billion (+22%, decelerating from +28% Y/Y in Q2).
Other Bets were $0.3 billion.
Main highlights:
Revenue grew +11% Y/Y to $76.7 billion ($1.0 billion beat).
Gross margin was 57% (+2pp Y/Y).
Operating margin was 28% (+3pp Y/Y).
Services (Advertising & Other) was 35% (+4pp Y/Y).
Cloud was 3% (+13pp Y/Y, -2pp Q/Q).
Earnings per share $1.55 ($0.10 beat).
Cash flow:
Operating cash flow was $30.7 billion (40% margin, +6pp Y/Y).
Free cash flow was $22.6 billion (29% margin, +6pp Y/Y).
Balance sheet:
Cash, cash equivalent, and marketable securities: $113.8 billion.
Long-term debt: $14.7 billion.
So what to make of all this?
Alphabet delivered its fastest revenue growth since Q2 FY20.
Ad rebound: Advertising revenue growth reaccelerated to +9% Y/Y from +3% Y/Y in Q2:
Search grew +11% Y/Y (vs. +5% Y/Y in Q2), led again by growth in retail.
YouTube grew +12% Y/Y (vs. +4% Y/Y in Q2). It was a critical rebound after an annual decline in Q4 FY22 and Q1 FY23.
Other (Subscriptions, Play, Hardware): This category grew +21% Y/Y, barely a slowdown from +24% Y/Y in Q2.
YouTube subscriptions (particularly TV, followed by Music and Premium) drove the strong growth (no exact number provided).
Management warned of a headwind in hardware last quarter, with the Pixel 7a released in Q2 FY23 while the Pixel 6a launched in Q3 FY22. That makes the continued momentum even more impressive.
Cloud’s concerns: Despite being the fastest-growing segment, Cloud's growth decelerated significantly to +22% Y/Y in Q2, from +28% in the previous two quarters. Management attributed this to customers optimizing workloads, a recurring challenge in recent quarters for hyperscalers. However, Amazon and Microsoft saw no slowdown in the same quarter (more on this in a minute).
Stock buybacks increased to $15.8 billion in Q3, compared to $15.0 billion in Q2, illustrating management's confidence in the stock’s value.
2. Recent business highlights
🧑⚖️ The antitrust trial of a generation
The ongoing US v. Google antitrust trial sets the stage for a critical verdict on digital monopolies.
Google’s deal with Apple to remain the iPhone's default search engine is under scrutiny. The deal is estimated at $20 billion per year (some of it involves a revenue share from traffic acquisition costs).
Microsoft's CEO, Satya Nadella, took the stand, expressing the challenge of competing in search. In a nutshell:
Despite Microsoft offering more, Apple won't take Microsoft's money to make Bing the default search engine on iPhone.
Alphabet has a lot more leverage than it looks on Apple because its platforms are used by billions of users (think Gmail, YouTube, or Maps). They could push for users to use Chrome vs. Safari. Apple devices are the gateway, but Google is a gatekeeper.
Alphabet has a data advantage and benefits from a flywheel effect.
AI could reinforce this flywheel even more, leaving competition in the dust.
The trial heats up further with Alphabet CEO Sundar Pichai’s testimony set for next week.
▶️ YouTube is (still) leading the pack
After a slowdown induced by Apple’s App Tracking Transparency, YouTube ads rebounded with easier comps. YouTube ads accounted for 94% of Netflix's revenue in Q3, a rise from 90% the previous year. Below is a chart comparing YouTube ad revenue to Netflix. YouTube Premium revenue data is not available, hence missing from the chart.
Advertising is more volatile and seasonal than a premium subscription service. Ads still have a minimal impact on Netflix’s overall revenue, as discussed in our coverage of the company’s earnings last week. This could change over time, with 30% of new sign-ups opting for the ad-supported plan.
Diving deeper, YouTube isn’t just about ads. Its premium services are tucked away under Alphabet's "Other" category, making YouTube a more significant revenue contributor than it first appears, likely closer to 15% of overall revenue.
Management has prioritized growth in YouTube Shorts (short vertical videos on YouTube, similar to TikTok and Reels), Connected TV, and subscription offerings:
YouTube Shorts now average over 70 billion daily views and are watched by over 2 billion signed-in users monthly. Management said they continue to work on “closing the monetization gap.” Shorts are still relatively under-monetized. In their earnings call, Meta said Reels is now “net neutral to overall company ad revenue,” an excellent leading indicator for YouTube Shorts.
YouTube TV recently launched its NFL Sunday Ticket. YouTube effectively offers the ultimate TV bundle for cord-cutters. Features like multi-view (watching up to four streams at once), livestream reliability, and the lack of latency could improve subscriber loyalty.
YouTube is leading all streaming platforms in the share of US TV time (aka “the living room”), reaching a 9.0% market share in September 2023 (excluding YouTube TV). That compares to 6.9% in the previous year. The platform reaches over 150 million people on connected TV screens in the US.
☁️ Cloud: Stumbling, but not out
Cloud grew by +22% Y/Y in Q3, decelerating from +28% Y/Y in Q1 and Q2.
Cloud operating margin contracted from 5% to 3% sequentially, while AWS expanded its operating margin from 24% to 30% during the same quarter.
So, how bad is this? In the same quarter, Microsoft and Amazon showed stronger momentum. Azure saw a slight acceleration sequentially from +27% to +28% Y/Y in constant currency. AWS saw no slowdown, maintaining growth of 12% Y/Y. Remember, Google Cloud includes GCP (Google Cloud Platform) and Workspace, making a direct comparison with AWS or Azure slightly complicated. Management reiterated that GCP growth is faster than the Cloud segment. GCP may be growing faster than Azure (albeit from a smaller base).
A client-mix issue? Some analysts suspect Google's vast exposure to smaller clients might be influencing the slowdown, given the swift AI integrations Azure and AWS have offered their larger Fortune 500 clients.
AI features have been slow to roll out. Particularly compared to Azure and AWS. But future prospects, such as the AI model Gemini, might reinvigorate growth next year (more on this in a minute).
Google Cloud is still growing faster than the market. According to Synergy Research Group estimates, cloud infrastructure spending grew +18% Y/Y to $68 billion in Q3. Amazon dominates (32% market share), followed by Microsoft (23%) and Google (11%). The big three make up 66% of the market.
3. Key quotes from the earnings call
CEO Sundar Pichai previously talked about the four ways to make AI helpful for everyone:
Knowledge & Learning: Incorporating AI into Search tools.
Boosting Creativity: Tools like Bard, Lens, and Duet AI.
Empowering Innovation: Offering Cloud AI models for developers.
Responsible Deployment: Ensuring AI is used with principles and efficiency.
He provided more details on multiple fronts.
On the launch of the Search Generative Experience (SGE):
“With Generative AI applied to Search, we can serve a wider range of information needs and answer new types of questions. […] We'll experiment with new formats native to SGE that use Generative AI to create relevant high-quality ads customized to every step of the Search journey.”
On boosting creativity with a conversational LLM:
“Bard can now integrate with apps and services, showing relevant information from Workspace, Maps, YouTube, and Flights and Hotels. We've also improved the ‘Google it’ feature. It provides other sources to help people evaluate Bard's responses and explore information across the web.”
On YouTube:
“We’ve heard positive feedback from our partners at the NFL about the new features and live stream reliability. This is a clear example of our ability to execute big partnerships with excellence and at scale.”
On Cloud:
“More than 60% of the world's 1,000 largest companies […] and more than half of all funded Generative AI startups are Google Cloud customers. This includes AI21 Labs, Contextual, Elemental Cognition, Rytr, and more.”
On Hardware:
“Pixel is the fastest growing smartphone brand in our top markets and the only one that grew in units sold year-over-year.”
On Other Bets:
“Waymo is onboarding more riders to its commercial ride hailing service as it gradually adds over 100,000 people from its San Francisco waitlist. Austin will follow as its next ride hail city. Wing and Walmart announced a new partnership to provide drone delivery service in the Dallas-Fort Worth area.“
Uber announced that riders may be matched with a self-driving Waymo vehicle in Phoenix starting this week. It could bring a large group of new riders to Waymo. So far, there is no indication that these rides will be cheaper, though we have no details on the unit economics.
CFO Ruth Porat on headcounts and efficiencies:
“We are maintaining a slower pace of headcount growth, reflecting product prioritization and reallocation of talent to support our most important growth opportunities.”
In addition, she mentioned optimization of the real estate footprint, engineering teams, and a focus on cost efficiencies across Alphabet. She also hinted at increased capital expenditures focusing on technical infrastructure, predominantly for AI compute investments.
4. What to watch looking forward
Here are significant shifts and launches to anticipate in the coming months.
Search Generative Experience (SGE)
Search remains 57% of Alphabet’s revenue. So it’s the most critical development to watch. Like the transition from desktop to mobile, this new transition to an AI-enhanced experience is only getting started.
The company is testing new ways to search, from creating images to writing an initial draft. It already looks more user-friendly than ChatGPT, with automated prompts to adjust a draft's length or tone. These features are still in development, but watch out for the rollout and reception.
Assistant with Bard
The company plans to integrate its Bard chatbot into Google Assistant. Taking cues from Amazon, the goal is to enhance the digital assistant via generative AI.
Users can interact with it through text, voices, or images in a way similar to OpenAI’s recent announcements for Chat-GPT. The launch is set for the coming months.
Gemini is coming
Created by DeepMind, Gemini is an upcoming AI system (or foundational model) that aims to compete with OpenAI's ChatGPT. Gemini is projected to rival and possibly outperform GPT-4.
Capabilities & Features:
Gemini combines the strengths of DeepMind’s AlphaGo with advanced language modeling (multimodal, integrating text, images, and more).
The AI system will power various tools, from chatbots to generating original text, including email drafts, music lyrics, and news articles.
Gemini may enable software engineers to write code and produce unique images based on user prompts.
Release & Access:
Alphabet granted a select group of companies early access to an advanced version of Gemini. New models will launch throughout next year.
While developers currently have access to a sizable version of Gemini, an even larger version comparable to GPT-4 is in development.
The company plans to make Gemini available to businesses via its Vertex AI service.
Market Context & Integration:
Gemini's introduction could reshape the AI landscape, especially given the company's vast computational resources and DeepMind's innovative AI research.
Pricing structures are emerging, with AI-powered tools offered to enterprise customers at $30 per user/month (like Microsoft’s Copilot).
In addition, Alphabet invested in AI startup Anthropic and has partnered with Meta to offer its Llama models to GCP customers.
The next Yahoo?
Prabhakar Raghavan, a senior executive at Alphabet, testified in the antitrust trial and underscored the challenge of maintaining search quality with roughly 8,000 engineers involved.
“I feel a keen sense not to become the next roadkill.”
He believes many threats exist beyond general search (like Bing). He gave specific examples of specialized searches:
Amazon is one of the companies he closely watches. Amazon’s advertising revenue is growing fast (+26% in Q3 FY23, an acceleration) and now represents 28% of Alphabet’s Search advertising revenue (+3pp Y/Y).
Online Travel Agencies like Expedia and Booking have improved their search capabilities, and some travelers may opt to go directly to a marketplace when looking for their next trip.
TikTok has become a relevant search engine for Gen Z, and “where young people go, older people follow.”
On Gen Z’s take on the search engine, he said:
“Grandpa Google knows the answers and will help you with homework, but when it comes to interesting things, they like to start elsewhere.”
Alphabet still dominates the global search market with a 92% share as of September 2023. According to Statcounter, Bing's US market share was 6.3% in September 2023, slightly down from 6.6% in March 2023, showing no improvement.
But the way we analyze the search market could be all wrong. The trend is not as clear if Amazon, TikTok, Airbnb, and more platforms are included in the mix.
“Nobody wakes up every morning and says I have to run a Google query.”
This challenge could expand as more GPT-like solutions emerge for personal and professional use cases.
The definition of the search market will be a critical point of the antitrust trial. But it’s also an important reminder for investors that the most significant threats might not come from the most obvious places.
We have more special reports coming up, each focusing on a unique theme within the tech industry. We'd love to hear from you.
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.