Alphabet impressed on the top line with revenue of $74.6 billion compared to estimates of $72.7 billion. This resulted in growth of 7%, or 9% on a constant currency basis, compared to 4% expected. What is important to note is that Alphabet is rebounding on margins and has now returned to the percentage they were at in Q1 2022.
This is important because margins had contracted about 500 basis points at their trough with a 23.9% operating margin in Q4 and have now returned to a 29% operating margin. This is a QoQ increase of 400 basis points. Operating profit of $21.8 billion matches Q4 of 2021 for record operating income. Cash flow margin was also up 440 basis points.
In our pre-earnings write-up, we highlighted that Alphabet was in the Year of Execution when we said: “One of the reasons the IO Fund has invested in larger cap stocks is that they are in a better position to navigate downturns. Big Tech also has more levers to pull to manage margins such as reducing operating expenses. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market from its weaker competitors. The medium-term bull case is that once top-line begins to meaningfully reaccelerate, the combination of right-sizing costs and efficiencies garnered from technology investments leads to expanding margins.”
Also, per our pre-earnings write-up, the CFO has said in the past they are in “Execution mode” in reducing costs and this will be evident not only in 2023 but “you will see more of it in ‘24.”
Management comments on the QoQ strength in margins were: “A quick comment on the sequential improvement in operating margins in the second quarter. There are two factors to note. First, the benefit from an acceleration in search advertising revenue growth in the second quarter. Second, the vast majority of the charges related to our workforce reduction and optimization of our global office space were taken in Q1.”
Another highlight we were looking for, per the pre-earnings write-up, was stabilization in YouTube and increased growth in Search revenue. Both materialized with Search up 5% and YouTube up 4%. These numbers are small for growth investors such as ourselves, but they also represent the strongest growth Google has reported in a year. We entered our current position with the idea that Google has bottomed and will accelerate from here.
Network advertising was weak at (-5.7%) but this is to be expected as mobile identifiers continue be sorted out and first-party data driven ads are more favored. Other revenues was a bright spot, up 24% and driven by “significant subscriber growth” for YouTube subscriptions plus the Pixel 7A.
Google Cloud was “better than peers” at 27.4% growth for an operating margin of 5%. The operating margin is double what it was last quarter, which was the first quarter to turn a profit. This is a positive on the evening of Microsoft’s report as Azure dipped below Google Cloud’s growth rate at 26%.
The CFO is moving to the new role of President and Chief Investment Officer.
Scorecard:
Stated in YoY growth % unless otherwise stated:
EPS and Revenue:
- Consensus of $1.34 (+11% y/y) vs $1.45 EPS Reported
- Consensus of $72.75B (+4.4% y/y) vs $74.6 billion Reported and 7% growth/9% on CC Basis
Sales by division in Q123 versus Q223:
- Google Search and other advertising – 2% versus 5% Q2
- YouTube advertising – (-3%) versus 4% Q2
- Network advertising – (-8%) versus (-5.7%) Q2
- Other – +9% versus 24.2% in Q2
- Google Cloud – +28% versus 27.4% in Q2
Margins:
- Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9% versus Gross Margin of 57.20% in Q2
- Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6% versus Operating Margin of 29% in Q2
Cash flow + Cash:
- Q1FY23 operating and free cash flow was $23.5B and $17.2B for a margin of 33.7% and 24.7%, respectively versus 38.40% op cash flow and 29.10% FCF in current quarter
Earnings Call:
Perhaps the most important question is why did Google grow this quarter when other ad-tech players are slowing down (or expected to slow down).
The answer was: “a lot of companies are focused on profitability, driving efficiencies, and they're carefully evaluating the effectiveness of their budgets. And our goal is really to help them maximize efficiency and drive strong ROI. And I think we have the proven AI-powered tools and solutions to actually do it. I called out Search and Other revenues being led by solid growth in the retail vertical. We talked about the DR and brand side on the YouTube side. I think those are the key points I would make.”
There were the obligatory questions about AI, of which this is probably the most important quote:
“It is an exciting moment overall in Cloud because there is definitely a lot of interest from customers on AI, and they definitely are engaging in many more conversations with us. So I would say, without commenting on the short term, but when I think about it long term, I view the AI opportunity as expanding our total addressable market and allows us to win new customers. Scale of investments that we can directly bring to cloud now. As I said earlier, we have over 80 models across Vertex, Enterprise Search and Conversational AI, and we are taking all of them, translating it into deep industry solutions. So, I'm excited about it. Second, it gives us an opportunity to upsell and cross-sell into our installed base.”
As Nvidia, AMD and Marvell investors (as a proxy), we want to keep an eye on capex. The comments were quite bullish in that regard:
“[..] that's why we wanted to be really clear that we do expect elevated levels of investment in our technical infrastructure, and that would be increasing through the back half of 2023, consistent with the comments we've made previously that we expected 2023 to be higher given the slower start at the front half of the year and then continuing to grow into 2024 [..] And the primary driver of this, as you know well, is to support the opportunities we see in AI across the Company, including the investments that we've already talked about, proprietary TPUs, all that we're doing with GPUs as well as data center capacity. And as we continue to see the pace of innovation accelerate, we just want to make sure we're positioned to address the opportunity across Alphabet.”
Conclusion:
We write out a lengthy and thorough pre-earnings report so our Members are aware of what to look for, and what in our eyes constitutes a strong report (or a weak report). It also helps us to eliminate biases. If a company isn’t up to par on the criteria we objectively set forth prior to the call, then we have to trim. Or, if a company clears a bar we set, then we look to add.
Suffice to say, Google has cleared the bar we set forth for our Members on Monday. You can look for us to add to this position soon.