As the women’s world cup commences, perhaps it’s apropos that both Microsoft and Google will report on 7/25 (amc). It will be a Big Tech “battle” of who can generate the most excitement on the AI opportunity and how that may impact their businesses in the future.
Given its cyclical exposure to advertising, Google’s valuation declined until it bottomed in early 2023, and has since increased due to the resilience of Search and optimism that AI will help strengthen it. Meanwhile, there are hopes that YouTube and the Network advertising businesses will stabilize. An aggressive focus on the stabilizing costs was another catalyst.
We recently initiated a position and we’ll discuss a few things we’ll be looking for in order to add to the position.
Here are the Q2FY23 estimates going into earnings announcement on 7/25 (amc).
EPS
- Q2FY23 consensus earnings of vs $1.34 (+11% y/y) vs Q123 $1.17 actual
- Q3FY23 consensus of $1.34
Group Sales
- Q2FY23 consensus of $72.75B (+4.4% y/y)
- Q3FY23 consensus of $74.3B
Sales by division in Q123
- Google Search and other advertising – $40.4B, +2% y/y
- YouTube advertising – $6.7B (-3%) y/y
- Network advertising – $7.5B (-8%) y/y
- Other – $7.4B +9% y/y
- Google Cloud – $7.5B, +28% y/y
Margins –
- Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9%
- Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6%
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
- Q1FY23 cash stood at $115B and $14B in debt
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.
In Q123, this is how Ruth Porat, Google CFO, characterized the impact of focusing on opex that began in late 2022.
Question
“And then, Ruth, backing out the one-time charges, it looks like OpEx growth is now 8%, so real progress there. Could you give us a flavor of where you are, you think in your optimization cycle?”
Ruth Porat
“We remain extremely focused on these various work streams that we have talked about. It starts with the pace of hiring. It goes to the various work streams that both Sundar and I referenced around using AI and automation to improve productivity, all that we are doing with suppliers and vendors to be as efficient as possible, all that we are doing around optimizing how and where we work. You have seen some of those announcements this quarter beyond the workforce reduction, things that we are doing in, for example, office services, and we are executing against each of these various work streams. So, our view is that there is more to do. And as we try to be clear, we are in execution mode. You will see some of the benefit in ‘23. You will see more of it in ‘24, and we are going to continue building against it beyond.”
Meta has described 2023 as the Year of Efficiency. We’ll refer to Google’s 2023 as the Year of Execution.
Here are the things we’ll be looking for:
- Google AI integration and impact across its business – This year Google introduced its chatbot BARD. Organizations are using large language models integrated within Google’s Search, Cloud, Workspace and Cybersecurity platforms.
To improve targeting in Core Search, Google has updated search keyword relevance using the latest natural language processing from MUM models to improve the relevance and performance of shown ads. Smart Bidding uses machine learning tools to optimize the bid of the advertisers. ML tools can analyze millions of data signals and can better predict future ad conversions.
We wrote about the potential impact AI may have here.
here. - Google Search – Q1 results demonstrated the resilience of search with its unique ability to surface demand and deliver measurable ROI. We will look for signs of accelerating growth.
- YouTube – look for continued signs of stabilization in its advertising exposed businesses and growth in its subscription based services. This is how Ruth Porat described it:
“YouTube, we saw signs of stabilization in ad spend on a sequential basis.”
- Network advertising – look for signs of stabilization and improvement. According to the CFO, investors can expect YouTube to be somewhat stabilized whereas Network is still decelerating: “And I would contrast that last quarter, we talked about both a pullback in YouTube and Network, and we were pleased that we saw the stabilization in ad spend on a sequential basis in YouTube. We still saw an ongoing pullback in Network, which tends to be a mix of businesses, as you know well.”
- Continued momentum in its Cloud business – for the first time Google had an operating profit in its cloud division. Q123 operating margins were 2.6% and represented 11% of sales. This is how Ruth Porat described it (which is bullish for AI accelerators from NVDA and potentially AMD and MRVL in the future):
“At the same time, I think at the core of your question, and what we were trying to convey is we will continue to invest to support long-term growth, in particular, given the opportunities we see delivering AI capabilities to our customers.”
However, the 28% growth rate may not be the bottom for Google Cloud:
“That being said, in Q1, we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”
- Capex outlook for FY 2023 – in Q1 Google raised their capex outlook and stated:
“Finally, as it relates to CapEx, for 2023, we now expect total CapEx to be modestly higher than in 2022. As discussed last quarter, CapEx this year will include a meaningful increase in technical infrastructure versus a decline in office facilities.”
This was reiterated later: “And then as we talked about last quarter, the increase in CapEx for the full year 2023 reflects the sizable increase in technical infrastructure investment, on the flip side, a decline in office facilities relative to last year.”
- FY2023 profitability and beyond – Now that Google is half way through their Year of Execution, we will look for any indications on this how may improve profitability once Network and YouTube advertising begin to improve.
- September 2023 anti-trust trial – We don’t expect anything from the call but wanted to remind our Members as that date is fast approaching. We wrote about the possible ramifications here.
Here’s what analysts are saying:
Stifel raised the firm's price target on Alphabet to $135 from $130 and keeps a Buy rating on the shares ahead of the company's upcoming earnings report. The firm is "slightly" revising higher its digital advertising growth forecasts for 2023 and 2024, though it is only expecting "slightly better results" for ad-based names relative to the top-line outperformance witnessed in Q1
BofA raised the firm's price target on Alphabet to $142 from $128 and keeps a Buy rating on the shares ahead of the company's Q2 report due on July 25. BofA forecasts revenue and GAAP EPS at $60.7B and $1.42 versus the Street at $60.4B and $1.34, respectively. The firm is constructive on stable search share trends, which it thinks will enable Google to control the pace of large language model integration
Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet and has a $150 price target on the shares.
KeyBanc analyst Justin Patterson raised the firm's price target on Alphabet to $140 from $122 and keeps an Overweight rating on the shares ahead of quarterly results. The firm believes Q2 is largely improved and growth should re-accelerate. In its conversations, investors perceive Alphabet as a "grind higher" stock given there is likely more limited upside to revenue from Search's vertical exposures and a theoretical ceiling on the multiple due to AI risk. That said, most investors acknowledge Street EPS forecasts appear conservative and that re-accelerating revenue growth provides some near-term reasons for optimism
Credit Suisse analyst Stephen Ju raised the firm's price target on Alphabet to $150 from $135 and keeps an Outperform rating on the shares ahead of quarterly results. Conservatively assuming ongoing headwinds in 2024 and normalization in 2025, the takeaway for Alphabet's shares is that even leaving upside potential from improving monetization potential for YouTube, Maps, and other non-Search surfaces off the table, the firm arrives at a positive investment conclusion. Switching focus to the more near-term, Credit Suisse's checks suggest an acceleration of year-over-year Search budget growth for Q2, as would be expected given easing comparisons. As for YouTube, the firm has received improving advertiser feedback quarter-over-quarter of increasing ad budgets, as CPG vertical spend recovers coinciding with what looks to be increasing ad loads.
Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet, maintains a Buy rating and $150 price target on the shares.
The I/O Fund Analyst Team contributed to this analysis