GOOG Earnings and Valuation
Alphabet put up very solid numbers this quarter, growing topline by 15% with GCP driving operating profits up 26%, and company wide margins coming in at 32%. Search surprised my estimates to the upside, showing growth of 14%, with retail and financial service verticals showing strength. YouTube came a bit light of consensus estimates but seems like mostly noise as it continues to dominate streaming hours. Cloud was very strong on the back of GCP with 29% YoY growth, breaking the $10B per quarter milestone, and operating margins coming in at 11%.
AI was obviously a big topic, and Sundar mentioned they are generating billions in revenue, mostly coming via GitHub Copilot. AI Overviews from search are popular and are seeing higher engagement, but the monetization questions around these answers are still yet to be determined. So far, search revenue hasn't been cannibalized and continues to show strong growth, which is a key bearish thesis around Google. Any sign of search cannibalization in the future will put a big dent in GOOG 0.00%↑ multiple.
From a cost perspective, they have done a good job managing opex growth but has been reinvesting the savings into infrastructure CapEx. Sundar admitted that it's an arms race, and the risk of falling behind compared to over-investing and generating a low ROI on the CapEx is much greater.
"I think the one way I think about it is when we go through a curve like this, the risk of under-investing is dramatically greater than the risk of over-investing for us here, even in scenarios where if it turns out that we are over-investing, we clearly -- these are infrastructure which are widely useful for us. They have long useful lives, and we can apply it across, and we can work through that. But I think not investing to be at the front here, I think, definitely has much more significant downside. Having said that, we obsess around every dollar we put in."
While he is right, the risk for shareholders here is that ROIC going forward will be much lower, which should drive lower multiples. There were a lot more questions from analysts around use cases and ROIC, and Sundar basically said it's early, and people are experimenting with different use cases. We are still in the early stages of AI implementation across different user bases, and so far, the use cases have been mostly the obvious ones. Even in code development, it's still early days, and models will continue to improve as they are refined.
"I think we are making these tools available to some of the most productive engineers and demanding engineers out there, and they are definitely kicking the tires hard. But I would say it's still all in very early stages, I think, particularly when it comes to writing high-quality secure code. But I think all the learnings, what we are gaining here will translate into our models and products, and that's the virtuous cycle which I'm excited by."
Now from a valuation standpoint, if we take sell-side consensus at face value, GOOG 0.00%↑ is trading at 29x '24 FCF and 21x '26 estimates of $105B of FCF and $56B in CapEx, or 13% of revenue. If Alphabet retains today's multiple of 28x FCF, the stock has ~35% upside or ~16% annualized returns over the next two years. A slight degradation in multiple to 25x still leaves investors with a respectable 10% annualized return. The downside is that Alphabet re-rates down to 20x FCF to account for slower topline growth, and the stock is flat over the next two years. This obviously assumes analyst estimates are directionally correct and underlying business trends do not dramatically change. The risk/reward on Alphabet is decent despite lack of huge upside potential and is a good place for index-hugging long shops to hide even during market downturns. From my perspective, a more attractive entry point from a valuation standpoint is $140-$150, which equates to a $1.7-1.8T EV.