While Alphabet (GOOGL)’s second-quarter results missed FactSet consensus estimates, we found the firm’s search advertising and cloud numbers encouraging. Google’s diversified advertising offerings appear to be partially offsetting uncertainties in the macro environment, while digital transformation to cloud remains on top of many businesses’ priority list.
We have slightly lowered our short- and medium-term expectations given the ongoing economic and geopolitical challenges, resulting in a $169 fair value estimate for Alphabet, down from $180. While the firm is taking steps to control costs at least through this year, with a strong cash-generating advertising business, progress toward profitability within its cloud segment, and a strong balance sheet, we think Alphabet is well-positioned to allocate more capital toward tuck-in acquisitions and investments.
Alphabet generated total revenue of $69.7 billion during the quarter, up 12.6% year over year, including the negative 3.7% impact of the stronger US dollar. While the firm claims some advertisers have been reducing spending, Google’s advertising revenue still grew 11.6% from last year with search and YouTube advertising revenue of $40.7 billion (up 13.5%) and $7.3 billion (up 4.8%), respectively. The firm’s other services revenue declined 1% from last year. Google cloud revenue increased 35.6% from last year to $6.3 billion. Google services' 36.2% operating margin combined with operating losses in other segments, resulted in total operating margin of 27.9% compared with 31.3% last year.
Share Price Reaction
Shares are up nearly 4% in pre-market trading but are down around 27% in the year to date.
Investment Case
Alphabet dominates the online search market with 80%-plus global share for Google, via which it generates strong revenue growth and cash flow. We expect continuing growth in the firm’s cash flow, as we remain confident that Google will maintain its leadership in search. We foresee YouTube contributing more to the firm’s top and bottom lines, and we view investments of some of that cash in moonshots as attractive. Whether they will generate positive returns remains to be seen, but they do present significant upside.
Google’s ecosystem strengthens as its products are adopted by more users, making its online advertising services more attractive to advertisers and publishers and resulting in increased online ad revenue, which we think will continue to grow at double-digit rates after the pandemic and during the next five years.
The firm utilises technological innovation to improve the user experience in nearly all its Google offerings, while making the sale and purchase of ads efficient for publishers and advertisers. Adoption and usage of mobile devices has been increasing. The online advertising market has taken notice and is following its target audience onto the mobile platform. We have seen Google partake in this on the back of its Android mobile operating system’s growing market share, helping it drive revenue growth and maintain its leadership in the space.
Among the firm’s investment areas, we particularly applaud the efforts to gain a stronger foothold in the fast-growing public cloud market. Google has quickly leveraged the technological expertise it applied to creating and maintaining its private cloud platform to increase its market share in this space, driving additional revenue growth and creating more operating leverage, which we expect will continue. Most of Alphabet’s more futuristic projects are not yet generating revenue, but the upside is attractive if they succeed, as the firm is targeting newer markets. Alphabet’s autonomous car technology business, Waymo, is a good example: Based on various studies, it may tap into a market valued in the tens of billions of dollars within the next 10-15 years.
