Earnings Preview | Google's profit margin under pressure, AI and cloud business are the focus

According to Zhitong Finance, Google's parent company Alphabet (GOOGL.US) is set to announce its second-quarter financial results after the U.S. stock market closes on Wednesday morning Beijing time. Investors will be closely watching the continued growth of its cloud business and the latest developments in its artificial intelligence (AI) initiatives. Analysts expect the company's Q2 revenue to reach $84.3 billion, a 13% year-on-year increase. Net profit is expected to reach $23 billion, or $1.85 per share, a 25% year-on-year increase.

Core Business: Search and Advertising Revenue

The key question for investors will be: Is there at least stable demand for digital advertising?

After 18 months of stagnation or decline, the cost per click for the search business increased by 8% in the first quarter. There are concerns that the demand for U.S. advertising from Asian retailers (such as Tianmu) may weaken, leading to price declines. Weak search click volume could suggest that new artificial intelligence tools from OpenAI/Microsoft and other companies are eroding Google's dominance.

Google under Alphabet continues to innovate in AI technology to drive the growth of its search business, expected to drive traffic to its platform in the upcoming quarter. The search business accounts for a significant portion of its total revenue.

Integrating generative AI technology into the search engine is expected to continue benefiting Google Search. With large language models (LLMs), Alphabet is likely to boost its search momentum in the second quarter. LLMs, along with multi-search and visual exploration features, are expected to further improve search results. Search Generative Experience (SGE) uses generative AI technology to make search results more natural and intuitive, potentially making a significant contribution to revenue.

SGE is expected to benefit the advertising business by creating relevant, customized, and high-quality ads. Google's advertising and Performance Max's advantages in conversational experiences may drive growth momentum among advertising clients in the second quarter. Improvements in YouTube advertising effectiveness are also a positive factor.

The company's strength in mobile search (based on algorithms tailored for mobile devices, a strong product lineup, and flight search capabilities) is a plus. It likely increased search traffic on the Chrome browser in the second quarter. According to Zacks data, analysts' general expectations for Google Search and other business revenue are $47.46 billion, an 11.3% year-on-year increase.x-oss-process=image/format,jpg/quality,Q_90)

In terms of advertising business, Alphabet is increasingly striving to provide advertisers with better performance and profitability under the support of basic research models and LLM, which is expected to make a significant contribution. The market's general expectation for Google's total advertising revenue is $64.28 billion, a 10.5% increase from the same period last year.

When it comes to non-advertising revenue from YouTube, the increasing momentum of users watching YouTube shorts may be a favorable factor. Google's efforts to strengthen relationships with content creators may have played a positive role. The growth momentum of Android and Pixel devices is expected to benefit Alphabet's performance in the upcoming quarter.

The above factors are expected to benefit Google's services sector in the second quarter. Zacks' general expectation for Google's service revenue is $73.43 billion, an increase of 10.8% from the same period last year.

Key Indicator: Cloud Growth

There is growing concern that investments by companies such as Alphabet, Meta Platforms (META.US), Amazon (AMZN.US), and Microsoft (MSFT.US) in data centers and computing capabilities may not bring substantial financial returns. Investors may focus on the continued growth of Google Cloud business, as revenue from the cloud division may help alleviate concerns about increased AI investment spending by large tech companies. According to Visible Alpha's widespread estimates, analysts expect cloud computing business revenue to reach $10.22 billion, showing growth from the previous quarter and the same period last year.

Alphabet's cloud products include Google Cloud Platform and Google Workspace, which continue to gain momentum in the thriving cloud computing market. Google's increasing investments in infrastructure, security, data management, analytics, and generative AI are major positive factors.

The expanding customer base of Google Cloud is expected to drive revenue growth for Alphabet in the second quarter of 2024. Revenue from the Google Cloud division, derived from fees charged for Google Cloud Platform services and Google Workspace collaboration tools, has been driving significant revenue growth for Alphabet. In the first quarter of 2024, Google Cloud revenue increased by 28.4% year-on-year, reaching $9.6 billion, accounting for 11.9% of total revenue for that quarter.

Business Focus: The Impact of Artificial Intelligence

Alphabet's efforts to integrate data lakes, data warehouses, data governance, and advanced machine learning into one platform are expected to enhance its prospects in the cloud market in the upcoming quarter. Its strong portfolio of cloud services, expanding data center network, availability zones, and regions have made significant contributions to Google Cloud's revenue. The powerful real-time data, analytics, and artificial intelligence, along with its open and scalable cloud infrastructure, are expected to help win customers in the upcoming quarter.

Alphabet has been increasing its investments in cloud customer business, including providing customers with more productivity-enhancing artificial intelligence tools. Despite Google still lagging behind Microsoft and Amazon in the cloud computing market, the company reported that its cloud computing division has been profitable for several consecutive quarters after years of losses.

The company's deep focus on generative artificial intelligence is expected to be a significant positive factor. Investors will be watching for updates on projects such as the artificial intelligence assistant Gemini Live and Project Astra, which could help Alphabet compete with Microsoft-backed OpenAI. Alphabet may shed light on how artificial intelligence overview is impacting Google search. The strong momentum of Gemini is expected to benefit Google Cloud's performance in the second quarter. The company has launched an enterprise-centric artificial intelligence code completion and assistance tool, Gemini Code Assist, which could drive its momentum across various enterprises.

Furthermore, the growth momentum of the Vertex AI platform is likely playing a significant role. Google has introduced various open-source tools to support generative artificial intelligence projects and infrastructure, which is a plus. New tools include MaxDiffusion (a reference implementation collection of various diffusion models), JetStream (a new engine for running generative artificial intelligence models), and MaxText (text generation artificial intelligence models for tensor processing units and integration with NVIDIA GPUs).

Also noteworthy is the latest update from the company on the Gemma family of open-source AI language models, including the addition of Gemma 2 - a new generation model with 27 billion parameters, and PaliGemma - the first visual language model for image captions, tags, and question-answering use cases. The introduction of these products is expected to benefit the revenue segment in this quarter.

The widespread adoption of generative artificial intelligence workspace tools may be another positive factor. In the second quarter of this year, Workday (WDAY.US) expanded its partnership with Google Cloud. Workday is leveraging the Gemini model and Vertex AI to help quickly generate AI-driven code, troubleshoot, and retrieve informationCintas CTAS has partnered with Google Cloud to develop a generative artificial intelligence knowledge center to accelerate its digital transformation. Cintas is using Google Cloud's Vertex AI to build a generative artificial intelligence-supported search engine to enhance employee capabilities.

Wiz Acquisition Details

Google Cloud's strong capabilities in identifying network threats and automating security workflows and responses with the support of generative artificial intelligence may be reflected in upcoming performance. Therefore, Google may also be considering a significant acquisition in the area of network security that has recently garnered market attention.

Previously, Jitong Finance reported that the company is in negotiations with the network security startup Wiz, planning to acquire Wiz for approximately $23 billion. If successful, this would be the largest acquisition ever made by this tech giant. Acquiring the cloud computing and network security company Wiz may help Google catch up with Microsoft and Amazon in the increasingly competitive cloud market.

Previously, Alphabet shelved its efforts to acquire the customer relationship management company HubSpot (HUBS.US). Similar to the HubSpot deal, considering the strict scrutiny from antitrust regulatory agencies that Alphabet faces, large-scale potential acquisitions like Wiz are not common for large tech companies like Alphabet. Google has already faced several antitrust challenges, including a lawsuit by the U.S. Department of Justice accusing it of abusing its dominant position in online search, as well as another lawsuit regarding its digital advertising tools.

Valuation Level

According to Morningstar data, analysts' fair value forecast for the company is $171 per share, equivalent to an enterprise value multiple (EV/EBITDA) of 15 in 2024. Given the company's continued investments in growth plans, primarily in artificial intelligence, and the need for higher levels of research and development, analysts expect slight pressure on profit margins in 2024. However, they anticipate an improvement in profit margins from 2025 to 2028, benefiting from better monetization of generative artificial intelligence search and faster growth in cloud computing, attributed to the widespread adoption of generative artificial intelligence. Morningstar's model assumes a compound annual growth rate of over 10% in total revenue over 5 years, with an average operating profit margin close to 29% over 5 years.

Analysts expect that with the continued growth in digital advertising spending, advertising revenue will still account for over 70% of Alphabet's total revenue, although the growth rate is significantly lower than historical levels. Due to the expected global economic growth being lower than in 2023, analysts project a 6.5% growth in advertising revenue in 2024. Analysts estimate Google's advertising revenue to be $253 billion in 2024 and $272 billion in 2025; by 2024, YouTube is expected to contribute 13.6% of Google's advertising revenue, slightly higher than in 2023, and to exceed 14% by 2025. YouTube's growth should benefit from its impressive coverage and usage frequency, along with its video content format, which is attractive to brand advertisersSince the beginning of this year, Alphabet's stock price has risen by nearly 30%. As of Friday's close, Alphabet's stock price was $177.66.