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Today, we will dive into Alphabet’s (NASDAQ:GOOG) (NASDAQ:GOOGL) 3Q23 results to determine how the company is holding up relative to expectations and whether there are any opportunities here.
How did Alphabet do in its 3Q23 results?
Alphabet 3Q23 results beat on revenue but missed on operating income.
Alphabet reported $76.7 billion revenue for 3Q23, up 11% from the prior year on a constant currency basis. This was 1% above consensus expectations.
However, operating income came in at $21.3 billion or 27.8% margin, which was 1% below consensus expectation. The main contributor to that was spend on R&D as that came in 4% above expectations.
GAAP EPS for 3Q23 came in at $1.55, above consensus by 6%. This was largely contributed by a lower tax rate of 7% compared to expectations of 16%, and the lower tax rate boosted EPS by $0.15.
Specifically, Google Cloud was a disappointment for the quarter.
Cloud revenue came in at $8.4 billion, decelerating to 22.5% year-on-year growth. This came in 2.6% below consensus, and also the year-on-year growth decelerated by 550 basis points from the prior quarter. Cloud operating profit came in at $266 million or 3.2% margin, compared to consensus of $324 million or 3.7% margin. I will comment more about the cloud optimization and generative AI trends in the next section
On the other hand, Search & Other revenues grew 11% from the prior year to $44 billion, 1.6% above consensus. YouTube advertising revenue grew 12.5% from the prior year to $8 billion, 1.6% above consensus as well. As a result, we can see that search and YouTube trends are showing an improving ad trend and is a positive read for players like Meta Platforms (META).
Google Cloud
Google Cloud is a key part of the investment thesis for Alphabet given the expected upside from the cloud and AI trends.
On the 3Q23 earnings call, management noted that optimization trends continued for Google Cloud in 3Q23:
GCP revenue growth remained strong across geographies, industries and products, although the Q3 year-on-year growth rate reflects the impact of customer optimization efforts.
For the Google Cloud business, there were undoubtedly customers looking to optimize spend, and that trend continued to be a headwind. However, management seems to be implying that with the strength and demand they are seeing with AI, it could help stabilize the overall cloud business and management is optimistic about what is to come.
However, the company is seeing lots of interest in AI, which is not surprising. In fact, just on Vertex alone, the number of projects grew more than 7 times sequentially.
Management also shared more about Gemini.
What is Gemini? Gemini is a multi-modal intelligence network that is capable of handling different types of data and jobs at the same time, processing text, images, audio, video, 3D models, and graphs.
This may mean that Gemini is thus more versatile that ChatGPT and GPT-4. In addition, I would also note that Alphabet has extensive access to a very massive range of proprietary training data that could enhance the performance of Gemini. Gemini is capable of processing data from various services, including Google Search, YouTube, Google Books, and Google Scholar, once again giving it a differentiation factor over other models.
This is a combined effort from the Google DeepMind team and the team is building the foundation for the series of next-generation models that will be launched through 2024. The company is creating it to be highly efficient, multimodal and with the ability to enable future innovations.
Of course, the elephant in the room and somewhat very glaring issue is that Microsoft (MSFT) happened to report on the exact same day and show that Microsoft Azure was generated better-than-expected growth and acceleration of growth.
While Google Cloud revenue missed expectations by 2.6% and decelerated by 550 basis points from the prior quarter, Microsoft Azure beat expectations by 2% and even accelerated 100 basis points from the prior quarter.
This likely showed that Microsoft Azure was better able to offset the cloud optimization trend that it was seeing with the improving deployments as a result of AI relative to Google Cloud.
Improving online advertising environment
Search grew 11% from the prior year and 6.5% from the prior quarter, highlighting that the advertising environment was improving. The strength was a result of the retail strength in Search, APAC and PMax.
Likewise, YouTube revenue growth also accelerated to 12.5% from the prior year and 8.1% from the prior quarter. This strength was contributed by both brand advertising and direct response.
According to commentary in 3Q23, management mentioned that there was a stabilization in advertiser spend and in particular, the ongoing performance with Shorts and Living Room is also doing well. The trends with Search are also helping with YouTube as retail strength in Search and APAC are contributing to the strength in YouTube this quarter. With stronger watch time growth and monetization.
Engagement on YouTube continues to expand across formats and content types. YouTube Shorts are now at more than 70 billion video views in a day, compared to 50 billion video views in day in just February this year.
According to Nielsen, YouTube remains the number one overall streaming platform and more than 150 million users watch YouTube on CTV screens monthly. NFL Sunday Ticket and YouTube Music adoption also seemed to be strong.
All that put together, it does seem that YouTube continues to be connecting and engaging with users well across formats and content types and executing well on this front.
All in all, the 3Q23 Search and YouTube advertising growth acceleration, along with stronger retail demand is suggesting that online advertising visibility continues to improve, and this is positive once again for players like Meta Platforms.
SGE and Bard to bring the future of Search
Search Generative Experience (“SGE”) is Alphabet’s answer to ChatGPT as a threat to its own Google Search engine.
The main idea is that SGE helps to improve Search with generative AI.
While SGE is still in beta, it is surfacing more links and content types, like video and generated images, compared to the traditional search.
This, I think, could bring about positive monetization benefits over time.
AI to bring more monetization opportunities
Management shared in the 3Q23 earnings call that the user feedback on SGE has been great and they have been rolling it out to more users. The team is ensuring that SGE works well and it is generating value for its entire ecosystem.
Bard Assistant was launched early in October and the usage of both SGE and Bard Assistant continues to grow.
Bard Assistant is a personal assistant that is powered by generative AI and it combines Assistant’s personalized help with Bard’s generative and reasoning capabilities.
With the rollout of more AI products, it also brings about more ad product innovation.
According to Alphabet, 80% of its advertisers use “at least one AI powered Search ad product”, like PMax.
In particular, during the 3Q23 earnings call, management shared that PMax is delivering 18% higher conversions at a similar cost per action.
Management also mentioned video reach campaigns, which will be generally available in November and the team is expanding it to in-feed and shorts.
As a result, AI enables advertisers to identify and locate their ideal audience for the lowest price. Based on early tests, Video Reach campaigns have resulted in 54% more reach at 42% lower costs.
R&D and capital expenditures
While the growth in revenues was faster than the growth in operating expenses for a second quarter, higher R&D investments resulted in weaker operating income.
That said, CFO Porat emphasized that Alphabet expects to re-engineer its cost basis by slowing hiring, rationalizing its real estate, improving productivity through use of AI and optimizing vendor and supplier spending.
Capital expenditures are expected to ramp in 4Q23 and through 2024. This is largely a result of infrastructure spend (servers and data centers), as Alphabet continues to invest in AI compute capacity with Nvidia’s (NVDA) H100 GPUs and TPU v5.
As a result, the aggregate capital expenditure costs for 2024 is guided to be higher than 2023.
Valuation
Alphabet is currently trading at just 18x P/E after the negative reaction to its earnings report.
I am rolling forward the 5-year financial forecasts from 2023 to 2027 to 2024 to 2028, given we are in the final quarter of 2023.
My 1-year price target is based on 20x P/E multiple.
As such, my 1-year price target is $136, revised marginally upwards.
Conclusion
One of the key takeaways was the improving advertising environment, as Search and YouTube Advertising both did better than expected and the commentary on both were also positive.
Google Cloud’s 3Q23 results was in contrast to that of Microsoft Azure, with slower AI rollout and continued cloud optimization weighing on growth. That said, I do think that most of the new AI products and features will launch in 2024 and that will be the year in which there could be upside to Google Cloud’s growth from AI deployments. I continue to be upbeat about the upside from generative AI offerings in the next year.
There are concerns about weakness in operating income as a result of elevated R&D spend, but there are two reasons why I am not worried about this as a long-term investor. Firstly, management already said that they will be re-engineering their cost base to ensure that margins remain stable. Alphabet has multiple levers to pull to ensure that margins are not compromised while investing in R&D. Secondly, the investment in R&D today is absolutely necessary for Alphabet to remain competitive and continue to innovate for a changing environment as AI takes the forefront.