🔎 Google: Profitable Cloud
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Alphabet (GOOG) (GOOGL), Google’s parent company, recently reported its Q1 FY23 earnings.
The earnings call allowed the leadership team to outline its AI strategy in the competitive landscape of big tech firms and provide updates on YouTube and Cloud. So let's dive in and put these developments into context.
Today, we’ll cover the following:
Alphabet Q1 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
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1. Alphabet Q1 FY23
Income statement:
Here is a bird’s-eye view of the income statement.
Revenue by segment (growth Y/Y):
Advertising: $54.5 billion (flat).
Google Search: $40.3 billion (+2%).
YouTube ads: $6.7 billion (-3%).
Google Network: $7.5 billion (-8%).
Google Other (Play, Hardware, Subscriptions): $7.4 billion (+9%).
Google Cloud: $7.5 billion (+28%, compared to +32% in Q4 FY22).
Other Bets were $0.4 billion, and hedging gains $0.3 billion.
Main highlights:
Revenue grew +3% Y/Y to $69.8 billion or +6% fx neutral (a $1.0 billion beat).
Gross margin was 56% (flat Y/Y).
Operating margin was 25% (-5pp Y/Y).
Google Services (Advertising & Other) 35% (-1pp Y/Y).
Google Cloud 3% (+15pp Y/Y).
Earnings per share $1.17 ($0.10 beat).
Cash flow:
Operating cash flow was $23.5 billion (34% margin, flat Y/Y).
Free cash flow was $16.0 billion (25% margin, +1pp Y/Y).
Balance sheet:
Cash, cash equivalent, and marketable securities: $115.1 billion.
Long-term debt: $13.7 billion.
So what to make of all this?
The growth in constant currency was +6% Y/Y and is a better representation of the business performance.
Advertising growth remained muted, with an ongoing pullback in ad spend.
Search grew moderately from an elevated base. For context, Google Search grew +23% Y/Y in Q1 FY22. The slow growth reflected an increase in the retail and travel verticals, partially offset by a decline in finance, media, and entertainment.
YouTube and Network declined. These segments were also lapping a tough quarter. In Q1 FY22, YouTube ads grew +14% Y/Y, and Google Network grew +20% Y/Y.
Google Other grew +9% Y/Y, a slight acceleration from Q4 FY22 (+8% Y/Y). YouTube subscriptions (Music, Premium, TV) saw strong growth (no exact number provided), partially offset by some softness in Google Play spending (particularly in APAC due to a considerable currency headwind).
It was the fifth consecutive quarterly with an overall profit decline. Charges related to recent layoffs and office space reductions (as expected) for $2.6 billion were partially to blame. However, they were offset by about $1.0 billion positive impact from adjusting depreciation expenses and stock-based compensation timing.
Capex in FY23 are now expected to be modestly higher Y/Y (compared to mostly flat previously). A rise in technical infrastructure expenses offset a decline in office facilities.
Management approved a new stock buyback program of $70 billion. For context, buybacks were $59 billion in FY22 and $14 billion in Q1 FY23.
Is the business sustainable?
Alphabet has a fortress balance sheet and is printing money, with over $60 billion in free cash flow generated in FY22. However, it’s essential to remember advertising is a cyclical business and doesn’t grow in a straight line.
As segments like Google Cloud and “Google Other” continue to shine, the company diversifies its revenue base. But disruption is unavoidable (more on that in a second).
2. Recent business highlights
YouTube’s growth avenues
I always enjoy updating the chart below every quarter, as it compares YouTube ad revenue to Netflix. Ideally, I would include YouTube Premium in these numbers, but we don't have access to the necessary breakdown. Of note, ads are much more volatile and seasonal than a premium subscription service like Netflix. Of course, things might change over time if Netflix relies more on its ad-supported tier.
Q1 is typically the weakest quarter of the year for ads. In Q1 FY23, YouTube ads made up 82% of Netflix revenue (-5pp Y/Y and -1pp Y/2Y), showcasing the current ad slump. YouTube has been gradually closing the gap over the past three years, so monitoring this trend in upcoming quarters will be interesting.
YouTube ads make up 10% of Alphabet’s overall revenue. But remember, premium subscriptions like Premium, Music, and TV are included with Google Play in the “Other” category. Management remains confident despite the ongoing ad slump and usually makes YouTube a critical section of the earnings call. The four priorities for YouTube are Shorts, engagement on larger screens (connected TVs), subscriptions, and making YouTube more shoppable.
YouTube Shorts are management’s priority. There is an entire short-video platform growing within YouTube. Management said Shorts averaged over 50 billion daily views in Q4 FY22, up from 30 billion a year prior. Now Shorts include revenue sharing to reward creators. Shorts are still relatively new and under-monetized (like Reels for Meta).
YouTube Music and Premium surpassed 80 million subscribers (including triallers) last quarter. Ruth Porat said there is “significant ongoing subscriber growth in both YouTube Music Premium and YouTube TV” but didn’t share specific numbers.
YouTube Primetime channels allow US viewers to browse, purchase, and watch TV shows, movies, and events from premium channels like Showtime and Starz, all within the YouTube platform. This feature eliminates switching between streaming apps and services, allowing users to watch purchased content across various devices, such as phones, tablets, computers, or TVs. Additionally, YouTube secured the NFL Sunday Ticket offering, which will help to drive subscriptions and bring new viewers to YouTube’s paid and ad-supported experiences. Subscribers will have to shell out $349 for the NFL Sunday Ticket for the season (or $249 on top of a monthly YouTube TV subscription).
YouTube is leading all streaming platforms in the share of US TV time, reaching a 7.8% market share in March 2023 (excluding YouTube TV).
YouTube more shoppable: Over 100,000 creators, artists, and brands have connected their Shopify stores to their YouTube channels to sell their products.
Google Cloud: still the fastest-growing and turning a profit
Google Cloud was 11% of the revenue. It grew by +28% Y/Y in Q1 FY23, a slowdown from +32% Y/Y in Q4 FY22. It was slightly faster than Azure (+27% Y/Y) and well ahead of AWS (+16% Y/Y). Remember, Google includes GCP (Google Cloud Platform) and Google Workspace, so it’s not a perfect comparison apples to apples to AWS or Azure. Management said GCP growth was “greater than Google Cloud” previously.
Google has an estimated 10% market share, steadily growing. Synergy Research Group updated its quarterly review of the cloud infrastructure services market, estimating Q1 2023 spending at $64 billion (+20% Y/Y and +4% Q/Q).
Google Cloud turned profitable with a 3% operating margin (+15pp Y/Y, +10pp Q/Q). It was a highlight of the quarter. However, CFO Ruth Porat has been clear that Google will continue to invest in long-term growth, and we should not extrapolate from quarter to quarter.
3. Key quotes from the earnings call
The prepared remarks were focused on three areas:
Advancements in AI driving opportunities in Search and beyond.
Efforts to sharpen the company’s focus.
CEO Sundar Pichai compared the transition to AI to the transition Google successfully made from desktop to mobile computing over a decade ago.
About Bard:
“In March, we introduced our experimental conversational AI service called Bard. We have since added our PaLM model to make it even more powerful and Bard can now help people with programming and software development tasks, including code generation, lots more to come. […] We will be bringing LLM experiences more natively into search as well.”
About AI already powering most of Google’s products:
“From Google Lens to multi-Search to visual exploration in Search, immersive view in Maps, Google Translate, to all the language models powering Search today, we have used AI to open up access to knowledge in powerful ways. […] AI has also been foundational to our ads business for over a decade. Products like Performance Max used the full power of Google’s AI to help advertisers find untapped and incremental conversion opportunities.
About the new organization around AI:
“We are bringing together the Brain Team in Google Research and DeepMind into one unit. Combining all this talent into 1 focused team, backed by the pooled computational resources of Google, will help accelerate our progress and develop the most capable AI systems safely and responsibly.”
About cost efficiencies:
“We are making our data centers more efficient, redistributing workloads and equipment where servers aren’t being fully used. This is important work as we continue to significantly invest in infrastructure to drive our many AI opportunities.”
About the cost of running LLM (Large Language Models):
“Costs of compute has always been a consideration for us. And if anything, I think it’s something we have developed extensive experience over many, many years. And so for us, it’s a nature of habit to constantly drive efficiencies in hardware, software and models across our fleet. And so this is not new. If anything, the sharper the technology curve is, we get excited by it because I think we have built world-class capabilities in taking that and then driving down cost sequentially and then deploying it at scale across the world.”
About Google Cloud Platform momentum:
“Over the past 3 years, GCP’s annual deal volume has grown nearly 500%, with large deals over $250 million growing more than 300%. Nearly 60% of the world’s 1,000 largest companies are Google Cloud customers, and many leading start-ups and millions of small and medium enterprises use Google Cloud. […] Over the last 4 years, the number of Google Cloud Partner certified practitioners around the world has increased more than 15x. […] And today, more than 100,000 companies are part of our Google Cloud Partner Advantage program.
About Google Workspace:
“We already have changes rolling out, and it’s an area where I think we will see the biggest advances because I think productivity is a strong use case in which generative AI can help.”
About YouTube:
“YouTube Shorts continues to see strong momentum with Creators. Last year, the number of channels that uploaded to Shorts daily grew over 80%. Those posting weekly on Shorts, saw the majority of new channel subscribers coming from their Shorts post. The living room remained our fastest-growing screen in 2022 in terms of watch time, and we are seeing growth and momentum internationally.”
Chief Business Officer Philipp Schindler touched on AI:
“AI has long been an important driver of our business. Advancements are powering our ability to help businesses, big and small, respond in real time to rapidly changing market and consumer shifts and deliver measurable ROI when it’s needed most. In Q1, we continue to innovate across our products. Take Core Search, for example. In targeting, we updated search keyword relevance using the latest natural language AI from MUM models to improve the relevance and performance of shown ads when there are multiple overlapping keywords eligible for an auction. In bidding, we improved our Smart Bidding models to bid more accurately based on differences in search ad formats. In other words, bid more effectively depending on how a user wants to engage with an ad. In creatives, we opened our automatically created assets beta to all advertisers in English. ACA generates text assets alongside your responsive search ads and uses AI to help reduce the amount of manual work to keep creatives fresh and relevant to users’ query, context and to the advertisers business.”
About AI serving Search:
“We’re actively helping more advertisers pair together with Performance Max. Advertisers who use PMax are, on average, achieving over 18% more conversions at a similar CPA. This is up 5 points in just 14 months, thanks to advances in the AI underlying bidding, creatives, search query matching and new formats like YouTube Shorts.”
CFO Ruth Porat on headcounts and efficiencies:
“We have efforts underway in three broad categories;
number one, using AI and automation to improve productivity across Alphabet for operational tasks as well as the efficiency of our technical infrastructure;
number two, managing our spend with suppliers and vendors more effectively;
and number three, continuing to optimize how and where we work. As we’ve noted previously, all three work streams are ramping up this year, and we plan to build on these efforts in 2024 and in subsequent years.”
4. What to watch looking forward
Google I/O announcements
Google I/O is scheduled for May 10th. Key points to expect from the big developer conference include:
Potential hardware reveals.
Potential AI announcements.
Updates on Android 14, ChromeOS, and other apps.
The event will be available online with a limited live audience.
The risks and opportunities of AI-powered search
As Microsoft incorporates OpenAI in all layers of its technology stack, it will be critical to watch the upcoming product releases and announcements from Google.
From The New York Times:
“Google’s employees were shocked when they learned in March that the South Korean consumer electronics giant Samsung was considering replacing Google with Microsoft’s Bing as the default search engine on its devices.
For years, Bing had been a search engine also-ran. But it became a lot more interesting to industry insiders when it recently added new artificial intelligence technology.
Google’s reaction to the Samsung threat was “panic,” according to internal messages reviewed by The New York Times. An estimated $3 billion in annual revenue was at stake with the Samsung contract. An additional $20 billion is tied to a similar Apple contract that will be up for renewal this year.
A.I. competitors like the new Bing are quickly becoming the most serious threat to Google’s search business in 25 years, and in response, Google is racing to build an all-new search engine powered by the technology. It is also upgrading the existing one with A.I. features, according to internal documents reviewed by The Times.
[…] The new search engine (project name Magi) would offer users a far more personalized experience than the company’s current service, attempting to anticipate users’ needs.”
I would highlight Sundar’s commentary from the earnings call here:
“As far as I can remember, we have always been in a competitive environment for these deals.”
Over the years, Microsoft has likely been working to position Bing as the default search engine for OEMs, such as Apple and Samsung. It remains uncertain whether Bing's new features will significantly impact its adoption. The forthcoming release of Google's AI-powered search engine, "Magi," will be an essential development to monitor as more information becomes available.
Get ready for the Search battle
“Search and other” was 58% of Google’s overall revenue in Q1 FY23. With a 93% share of the global search market in March 2023 (slightly up from December), Google continues to dominate, leaving Bing with less than 3% market share. This raises the question of whether an OpenAI-powered Bing can emerge as a genuine contender in this category. During Microsoft's earnings call, Satya Nadella mentioned that Bing was growing its share in the US, but he didn't provide specific numbers.
According to Statcounter, Bing's US market share was 6.6% in March 2023, slightly down from 6.7% in December 2022. This indicates that if there's any shift in the coming quarters, it hasn't begun just yet.
That’s it for today!
Stay healthy and invest on!
Disclosure: I am long GOOG and AMZN in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
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.
How about SBC impact on FCF margins