Alphabet’s Q3 report was strong on the headline: GAAP EPS of $1.55 beat estimates by $0.10, while revenues of $76.79 billion beat estimates by $0.98 billion. Revenue growth accelerated to +11.0% for the quarter, ahead of the expected +9.7% growth figure and much higher than the +7.1% growth in Q2 and the +6.1% growth in Q3 last year.

Operating margin expanded ~300 bp during the quarter to 27.8%, as Google Services’ segment operating margin rose to 35.2% compared to 30.8% in the year-ago quarter. Net margin for the quarter was 25.7%, increasing ~560 bp from 20.1% last year.

We highlighted four key factors back in August that drove our optimism for revenue acceleration with upside for margins through the end of this year:

1. Resilience in Search
2. stabilization in YouTube Ads
3. Market share and profitability gains in Cloud
4. Growth in Other Google (i.e. YouTube subscription)

Three of those points have panned out this year – Search growth has accelerated tremendously, YouTube Ads growth has picked up its pace, and growth in Other Google also accelerated; Cloud is the only disappointment so far, with revenue decelerating during Q3.

For a deeper dive into Alphabet and how the Search giant is entering its Year of Execution, read more here.here.

Revenue and EPS:

• Revenue of $76.79 billion beat estimates by 1.3%, representing growth of +11.0% YoY
• Search revenue of $44.04 billion grew by +11.3% YoY
• GAAP EPS of $1.55 beat estimates by 6.5%, representing growth of +46.2% YoY

Margins:

• Gross margin of 56.7% increased ~180 bp YoY from 54.9%, but decreased ~50 bp QoQ from 57.2%
• Operating margin of 27.8% increased ~300 bp YoY from 24.8%, but decreased ~150 bp QoQ from 29.3%
• Net margin of 25.7% increased ~560 bp YoY from 20.1% and increased ~110 bp QoQ from 24.6%
• Operating cash flow margin of 39.9% increased ~610 bp YoY from 33.8% and increased ~150 bp QoQ from 38.4%
• Free cash flow margin of 29.4% increased ~610 bp YoY from 23.3%

Cash & Debt:

• Total cash, equivalents and marketable securities of $119.9 billion; cash and equivalents on hand of $30.70 billion increased +40.3% from $21.98 billion
• Operating cash flow of $30.66 billion increased 31.3% YoY from $23.35 billion; YTD operating cash flow of $82.83 billion increased +22.0% YoY from $67.88 billion
• Free cash flow of $22.60 billion increased +40.6% YoY from $16.08 billion; YTD free cash flow of $61.60 billion increased +40.0% YoY from $43.99 billion
• Total debt of $13.78 billion

Segment Results:

• Search revenue of $44.03 billion increased +11.3% YoY, highest growth rate since Q2 ‘22
• YouTube Ads revenue of $7.95 billion increased +12.5% YoY, highest growth rate since Q1 ‘22
• Google Other revenue of $8.34 billion increased +20.9% YoY, second straight quarter with greater than +20% growth
• Google Cloud revenue of $8.41 billion increased +22.5% YoY

Search Growth Accelerating, Boosting Services Segment Margin

Search’s growth stole the show in Q3, with growth quickly accelerating to a double-digit rate — Search added ~$4.5 billion in revenue YoY and ~$1.4 billion QoQ, reaching a record level. Alphabet sees AI as driving the next ‘major evolution’ of Search, and evidence of that is already surfacing as generative AI tools are being integrated into Search and accelerating revenue growth at scale.

Growth in Search cooled rather quickly through 2022 as a challenging macro environment rapidly replaced a surging ad spending environment in 2021, with revenue growth bottoming out at a (1.6%) YoY decline in Q4 2022. Just three quarters later, Search returned to double-digit growth, accelerating in each quarter this year – rising from a ~$160 billion annualized run rate in Q1 to a ~$176 billion annualized run rate in Q3.

This acceleration in Search revenue alongside strong double-digit growth in YouTube Ads revenue and Google Other (YouTube subscriptions, etc.), significantly boosted margins. Not only is AI helping drive higher ROI and increased engagement for Google’s advertising customers, but it’s also showing an incrementally large boost to Google’s Services segment margin.  Compared to the year-ago quarter, Google’s Services segment added ~$6.6 billion in revenue, and from that ~$5.0 billion in operating income.

A quick note on Search:

I/O Fund said prior to earnings that “Alphabet’s Search ‘has proven resilient because it provides advertisers an attractive ROI on their ad spend. Looking ahead, Search Generative Experience, [Google’s generative AI-powered search tool], will improve advertisers’ ROI and will likely provide Alphabet additional pricing power. This will also improve their retail vertical’ – a trend already surfacing, with Q2’s Search growth driven by retail alongside SGE’s launch.”

The retail vertical again drove growth in Search in Q3, while management was upbeat about SGE and experimenting with new native ad formats in the tool. CEO Sundar Pichai said that “direct user feedback [for SGE] has been positive with strong growth and adoption,” with Google rolling the tool out to India and Japan with more countries and languages to come.

Google Cloud’s Deceleration Continues

Weighing down on strong results in Search and YouTube was Google Cloud, which saw growth decelerate once more to the low-20% range while Microsoft’s Azure saw a marginal acceleration this quarter to 28%.

Cloud’s revenue growth dropped to +22.5%, down from +28.0% in Q2 and +37.6% in the year-ago quarter. Aside from the deceleration, Google Cloud recorded its third-straight consecutive quarter with a positive operating margin; however, its operating margin declined ~170 bp QoQ to 3.2%.

The segment’s deceleration is particularly concerning this quarter, and even more so should it continue again in Q4, given the segment’s size relative to Microsoft’s Intelligent Cloud and Amazon’s AWS.

Google Cloud operates at a ~$34 billion annual run rate, compared to an ~$97 billion run rate to Microsoft’s Intelligent Cloud and ~$88 billion run rate for AWS. At its size, Google Cloud should theoretically be posting higher growth rates based on the law of large numbers, so this sharper deceleration raises red flags that:

1. AI products are not boosting revenue as much as expected in the near term
2. Azure is commanding a higher share of AI-based cloud spending, helped by its tie-in with OpenAI via APIs
3. Cloud spending is shifting away from Google to Azure and AWS

CFO Ruth Porat said Cloud’s “Q3 year-on-year growth rate reflects the impact of customer optimization efforts,” signaling that some cloud customers may still be reining in spending. She added that “Google Workspace also delivered strong revenue growth, primarily driven by increases in average revenue per seat.” Overall, Porat said Alphabet was “pleased with the ongoing customer engagement with GCP and Workspace and the potential benefit of our AI solutions including infrastructure and services such as Vertex AI and Duet.”

Earnings Call:

Alphabet’s earnings call reiterated the fact that the company is “definitely seeing a lot of interest in AI,” as executives highlighted how AI is driving higher ROIs in advertising while discussing the need to continually invest in AI.

On the advertising side, SVP Philipp Schindler said that Alphabet’s “our proven AI-powered solutions like Search and PMax are helping retailers drive reliable, strong ROI and meet customers wherever they are across the funnel.” He added that PMax “gives advertisers really maximum performance across all inventory from, one, really AI-powered campaign, and it's probably the ultimate example of AI in action across our ads product. It's delivering excellent ROI. Those using it achieve like on average, over 18% more conversions at a similar cost per action.” In addition, “AI is helping advertisers find as many people as possible in their ideal audience for the lowest possible price. Early tests are delivering 54% more reach at 42% lower cost.” As Alphabet continues to roll out and improve AI-focused advertising solutions, it can continue to drive ROI and capture larger amounts of advertising spend throughout Search and YouTube.

With that in mind, Porat discussed how Alphabet will “continue to invest meaningfully in the technical infrastructure needed to support the opportunities we see in AI.” She said the company is expecting “elevated levels of investment, increasing in the fourth quarter of 2023 and continuing to grow in 2024,” this 2024’s “aggregate CapEx will be above the full year 2023.”

Conclusion:

Alphabet’s Q3 was a very solid report under the surface, with Search’s rapid reacceleration and Services’ major increase in operating income overshadowed by Google Cloud’s deceleration. Heading into a seasonally strong Q4 for advertising, Alphabet looks poised to reach record Advertising revenues and another record quarter for Search, boosted in part by AI integrations and SGE. Both showed signs of strength in Q3: Search revenue reached a record high, while Ad revenue rose to a seven-quarter high of $59.6 billion.

Moving on to Q4 and 2024, Google Cloud will remain in focus, and if revenue growth can inflect sooner rather than later, given that Azure is showing signs of stabilization shifting towards acceleration. AI’s impact on Search and Ads will also be watched – Alphabet is currently projected to post double-digit revenue growth in each quarter of 2024, driven by Ads and Search.

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I/O Fund Equity Analyst Damien Robbins contributed to this report.

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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.

Recommended Readings:

• I/O Fund Portfolio & Must-Read Theses
• Google Q2 2023 – Year of Execution
• Microsoft Q4FY23 Pre-ER: Looking to build AI momentum into FY24
• Cloud Q1 Update: When Will the QoQ Decel Find a Bottom?
• Highlights from Google I/O 2023