AI Business Efficiency, AI Product Innovation, AI Expenditure Investment... (Alphabet-C 4Q23 Conference Call Summary)

Here is the summary of the earnings conference call for the fourth quarter of 2023 for Alphabet(GOOGL.US). For the interpretation of the earnings report, please refer to Alphabet-C: Expectations Too High, CEO Douses Cold Water.

I. Review of Key Financial Information:

1. High market expectations, "slightly disappointing" advertising: Throughout 2023, the advertising market has been in a period of recovery. With the boost from the e-commerce battle in the second half of the year, the advertising platform has reaped significant gains. Therefore, Alphabet-C, as the leader in advertising, naturally performed well. In the fourth quarter, advertising remained strong, with the growth rate accelerating from 9.5% in the previous quarter to 11%. However, the market expectations in recent times have been too high, such as the expectations for search advertising. The consensus expectations from Bloomberg cannot reflect the core expectations in the past few days, resulting in post-market sentiment release and a 6% drop in stock price.

2. Cloud business benefits from AI, rebound as expected: In the previous quarter, Alphabet-C's cloud business experienced a "minor setback," with its growth rate slowing down while its peers accelerated or reached the bottom of their growth rates. However, Dolphin Research mentioned that there is no need to worry about the cloud business based on changes in indicators such as remaining contract value. The 10% drop is only for a single quarter and is not significant. For more details, please refer to the previous earnings report review or the YouTube video "Alphabet-C Earnings Q&A." In the fourth quarter, the cloud business rebounded as expected, with a year-on-year growth rate of 25%. Pichai revealed during the conference call that the cloud business has seen an increase in demand driven by Gen AI and is continuously increasing its contribution to cloud revenue. As Alphabet-C's cloud business returns to a new growth trend, the cycle of enterprise-side capital expenditure reduction is quickly fading with the AI wave. Not only will Alphabet-C's clients increase their capital expenditure this year, but Alphabet-C itself will also increase its capital expenditure to support its AI business.

1. Other businesses exceed expectations again: In the fourth quarter, revenue from other businesses performed excellently and showed accelerated growth. Dolphin Research believes that, similar to the previous quarter, this is mainly due to the benefits from YouTube subscriptions, Google One subscriptions, and Pixel phone sales. With the gradual recovery of the Android smartphone market, it is expected that Google Play's revenue will also have some growth support in the future. However, the recent buzz about Apple's tax reduction has caused a stir, and even the big brother has compromised. Google Play will likely have to follow suit. The market expects that a 10 percentage point reduction in revenue sharing would mean an impact of 3-4 billion USD, accounting for 1% of the total revenue in 2023.If we assume an 80% profit margin, which translates to an operating profit of 25-30 billion, the impact would be around 3%-4%.

2. The incremental investment in AI may have already been reflected: Dolphin Research has been pondering when and to what extent the cost of this round of AI large-scale models will have an impact, especially after the popularity of ChatGPT. Looking at Alphabet-C's quarterly report, we can see some incremental changes in expenditure.

(1) Although Alphabet-C's gross margin in the fourth quarter increased by 2% YoY, the cost breakdown shows that the increase in traffic costs is only 8%, which is not significant. However, the depreciation and amortization costs of servers are still growing by 5%, even though the depreciation period has been extended (from January 2023, changing from four years to six years). This indicates that Alphabet-C has invested in additional servers, network equipment, and other infrastructure.

(2) R&D expenses showed a significant acceleration in YoY growth compared to the third quarter, reaching 18%. The increase in marketing expenses may be related to cloud services and Pixel phone sales.

(3) The number of employees decreased by 7,700 YoY (more than 3,000 more than the net decrease in the third quarter), but the average employee-related expenses and average employee stock incentive expenses both increased YoY, and the growth rate accelerated compared to the third quarter. This indicates that the proportion of high-salary employees in the employee structure has further increased.

In the end, although the high-profit-margin advertising growth in the fourth quarter was strong and rebounded rapidly, the overall operating profit margin of the group did not increase MoM and remained at 27.5%. Looking at the business segment level, the operating profit margin of Alphabet-C, which is mainly focused on advertising, remained flat at 35% compared to the third quarter. The operating profit margin of cloud services improved to some extent MoM (9.4% in 4Q vs 3.2% in 3Q), which was also better than market expectations. However, the profit from cloud services is relatively small compared to advertising, so its contribution to overall profitability is limited.

1. An overview is as follows:

II. Detailed content of the earnings conference call

2.1. Key points from the management's statement:

1. Artificial Intelligence and Search: Gemini was launched at the end of 2023 and applied to search. The next version, Gemini Ultra, is about to be released. a) Circle to search will be launched on Pixel8, Pixel8 Pro, and the all-new Samsung Galaxy S24 series. b) Lens provides a generative AI overview and allows text to be added to visual searches.

2. Subscriptions: The annual revenue from subscription businesses reaches as high as $15 billion, with YouTube being the main driver of subscription revenue. Google One is growing well, and the number of users is about to exceed 100 million.

3. Alphabet-C Cloud: Customers such as Antropic, Character Al, Essential Al, and Mistral AI are using Alphabet-C Cloud to build and provide models. The enterprise AI platform, Vertex Al, helps clients like Deutsche Telekom and Moody's deploy over 130 GenAI models. In the workspace domain, Duet Al is assisting thousands of paying customers' employees in improving productivity and creativity.

4. Significant improvements have been made in areas such as procurement by increasing supplier efficiency and automating certain processes, resulting in substantial cost savings.

5. Advertising and Search: Alphabet-C's service revenue reached $76 billion, a YoY growth of 12%. Advertising, search, and other business revenue under Alphabet-C saw a YoY growth of 13%. Advertising still has growth potential in the long term, with immersive visual creativity on YouTube helping social advertising clients find and convert consumers. The search business performed exceptionally well in the fourth quarter, with retail being a highlight. Growth was driven by one-stop discount destinations, new filters like GetItFast, and new features such as AI-generated gift recommendations in SGE during key shopping moments like Cyber Five.

6. YouTube: YouTube's advertising revenue grew by 16% YoY, while network revenue decreased by 2%. Subscription, platform, and device businesses saw a 23% YoY revenue growth, driven by strong growth in the subscription business. a) Creation: More content creation is happening on mobile devices, including the development of new YouTube Create short video applications. b) Audience: Viewing time continues to increase, with short videos remaining a priority. YouTube has over 2 billion logged-in users per month, with an average of 70 billion daily views. The living room is the fastest-growing area for audience growth.

7. Alphabet's revenue in 2023 reached $307 billion, a 9% growth compared to 2022, with a total annual revenue increase of $25 billion. The annual free cash flow was $69 billion. Alphabet repurchased a total of $62 billion worth of Class A and Class C shares in 2023, ending the year with $111 billion in cash and securities. a) In the fourth quarter, consolidated revenue reached $86.3 billion, a 13% YoY growth, with the search business remaining the largest contributor to revenue growth. b) Total cost of revenue was $37.6 billion, a 6% increase. Other cost of revenue was $23.6 billion, a 5% increase, primarily due to content acquisition costs related to YouTube subscription products. c) In terms of total expenses, an additional $1.2 billion in relocation costs was incurred in the fourth quarter compared to the same period last year due to optimizing global office space.

2.1 Q&A Analyst Questions and AnswersA: As we have mentioned in previous quarters, AI has always been at the core of Google's advertising products. Recent advancements in AI have allowed us to create more value for advertisers in various areas such as bidding, targeting, creatives, and the overall advertiser and publisher experience. For example, in the bidding for core search ads, value-based bidding is crucial in targeting, and the broad matching of creative and responsive search ads automatically creates ad assets. We are very pleased with Google's progress in these areas.

Regarding obstacles and limiting factors, AI elements remain neutral, aiming to make everyone ready to fully leverage these tools. We have also mentioned the progress of PMax, and we are very satisfied with 4Q23. So overall, I believe we are moving in the direction we expect.

Q: Sales team intensity: With the increasing impact of more AI-based tools, such as Pmax, on overall ad allocation, how do you view the long-term sales intensity of the advertising business?

A: In terms of sales team intensity, we have made some reallocations, or what we call "portfolio adjustments." As you know, we have two distinct large teams: LCS (Large Customer Solutions), which focuses on the transformation and transformative growth of our largest and most complex customers, and GCS (Global Customer Solutions), which is the channel that touches every customer, from some of our largest customers to millions of small and medium-sized businesses.

GCS expands growth by dynamically providing the right services for each customer. It is worth noting that this is also our fastest-growing channel, with particularly strong growth in 4Q23. So we made adjustments to concentrate more resources on GCS.

But I also want to make it clear that whenever we reorganize, there is always an opportunity to become more efficient and smarter in serving and developing customers. We are not reorganizing because AI is taking away important opportunities or playing a more significant role, but because we see the tremendous opportunities brought by our AI solutions, which can actually provide incredible ROI at scale, and that is why we are making some adjustments. Therefore, sales team intensity in these channels will be a stronger focus in the future.

Q: Cost adjustments: Now is the second year of Google's ongoing redesign of cost structure. Can you evaluate the current progress? Are there any milestones that we should consider?A: We are very pleased with the progress we have made and are committed to this framework to fundamentally redesign our cost base and invest in growth priorities. I tried to highlight some of them in the opening remarks, but in reality, when you see what Google and Alphabet are doing, it really starts with prioritizing the handling of products and processes to ensure that we have the right resources behind the most important opportunities, which provides us with the opportunity to reallocate resources where we can. In addition, we talked a lot about organizational efficiency and structure in 4Q23, focusing on eliminating layers to simplify execution and increase speed.

The combination of product prioritization/adjustment and organizational design work has resulted in a slowdown in hiring speed, as seen in the YoY decrease in our employee numbers, which is also reflected in our performance in the fourth quarter. This also applies to the 1Q24 announcement and the slowdown in hiring speed. At the current point in 1Q24, we estimate that the expenses related to layoffs and dismissals will be approximately $700 million, as these efforts continue. But as I mentioned in the opening remarks, we will continue to invest in top engineering technology and engineers.

Starting with product prioritization and organizational design, as well as the explanation of expenses related to layoffs, helps pave the way for us to continue doing what we are doing. But we have many other workflow improvements, including improving the efficiency of our technical infrastructure, streamlining Alphabet's operations through AI, including our collaboration with suppliers and distributors, and optimizing our real estate investment portfolio. Therefore, as we describe the ongoing restructuring efforts, they are built on the work that has already begun and is in progress.

Q: NFL Sunday Ticket: What were the main achievements/lessons learned in the first year? How do you consider the return on investment from both an advertising perspective and from the perspective of Sunday Ticket and YouTube TV subscribers?

A: NFL Sunday Ticket supports our long-term strategy and helps solidify YouTube's position as a must-have application on everyone's TV.

Regarding lessons learned and achievements: In terms of the viewing experience, we have received positive feedback so far; people like the navigation, MultiView, chat, and the seamless experience without any delays.

Regarding advertising and subscriptions: On the subscriber side, we are pleased with the number of registrations for NFL Sunday Ticket in its first season, which can be accessed as part of the YouTube TV bundle or as a standalone product for YouTube Primetime Channels. Additionally, there are no further points to share.

In terms of advertising, as you know, advertisers can purchase ads from the NFL lineup as part of our curated YouTube portfolio. This actually allows advertisers to reach football fans through YouTube's unique breadth of NFL content, whether they are watching live games on YouTube TV or Primetime Channels.Still watching NFL highlights and post-game commentary on the YouTube channel.

We have seen strong demand in the advertising market for NFL Sunday Ticket and are excited about our future partnership; this is our first season. As I mentioned before, in our first year, we had multiple (90) advertisers collaborating with YouTube to provide advertising opportunities during the NFL Sunday Ticket season, and we are very grateful for that.

Q: SGE (Search Generative Experience): When considering the development of more traditional search products and Google Assistant in the world of SGE and Bard in the next few years, what does this mean for commercial and non-commercial search elements, and how might use cases change in the coming years?

A: Clearly, it is an exciting time. As I mentioned, the early feedback has been positive as we integrate SGE into our products, and we have been iterating on it. SGE clearly works well for certain types of queries, and we are expanding the set of queries it performs well on. SGE is answering certain categories of queries in a better way for the first time, which gives us a direction to move forward.

Overall, I think people underestimate the breadth of search, the volume of queries that we see every day, which is unprecedented. So the trick here is to provide a high-quality experience within the scope of search that we see.

Over time, we believe Assistant will be a very good complement, and we will again use generative AI, especially our most advanced models and Bard; over time, its behavior will be more like an agent. We will follow users more closely and provide a good experience, and that's the direction where the opportunity lies. Obviously, there is still a lot of work to be done, but AI is an area where I think we have a deep understanding and experience. So far, all the work we have done has received very positive feedback.

Q: One-timers: From the financial reports and public comments, it can be seen that some one-time factors are not allocated to business segments but are more related to Other Bets and activities at the Alphabet group level. Can you confirm how one-time factors are reflected in the P&L and any one-time factors that may be relevant in 1Q24?

A: The $1.2 billion in real estate-related expenses is an activity at the Alphabet group level. We have a table that IR can help everyone understand how these factors are reflected in the various items of the P&L and other technical issues.

Q: Considering the importance of YouTube to Connected TV, can you talk about the market opportunities for Connected TV outside of the United States? What has the company done to promote the popularity of YouTube or Connected TV with Alphabet-C's operating system?In terms of things worth discussing outside of the United States:

A: In terms of Connected TV, as I mentioned before, it continues to perform well. I previously mentioned that YouTube is the leader in streaming watch time in the United States, and the expansion of its audience is very deep. Internationally, we are closely monitoring the situation. At this time, I don't have anything specific to share.

Q: Over the past year, you have consistently emphasized the advantages of Shorts. Can you talk about the challenges of monetization? Can you still see the resistance you initially encountered? Can you share the ad density of Shorts to help us determine whether it is a resistance or growth now?

A: We created Shorts to meet the huge demand from creators and viewers. We are very satisfied with the growth we have seen. I mentioned over 2 billion monthly users and 70 billion daily views. Especially in terms of monetization, Shorts' profitability continues to make good progress. In fact, since we introduced the revenue sharing mechanism for Shorts, the total creator revenue for Shorts has been growing every month, and we believe this trend can continue. It is clear that, just like with our long-form videos, we are committed to building a long-term business. As I mentioned before, when creators succeed, we succeed.

Q: PMax has been launched for two years now, and it can help small and medium-sized enterprises create ideas, manage expenses, and maximize return on investment across multiple Alphabet-C services. How do you view it for those small and medium-sized enterprises that couldn't advertise with you before? In the long run, what kind of driving force does it bring to your market expansion and revenue growth?

A: We have mentioned several times before that small and medium-sized enterprises are our focus. They are part of our GCS channel, and they have undergone a lot of changes in the past few years. Our focus here has always been on investing in solutions that truly contribute to creating a fair competitive environment, and you mentioned some of them.

Therefore, in reality, small and medium-sized enterprises are able to compete with larger brands and more experienced advertisers. The feedback we always receive is that they need simple solutions that can quickly drive value, and the AI solutions you mentioned in some parts actually make the workflow and the entire entry ramp and bidding more creative, making it easier for small and medium-sized enterprises, as you mentioned.

So we are very satisfied with what we have seen, and we will continue to invest. I think AI is indeed a useful and very interesting path for the future. It will not only make life easier but also more efficient, and over time, it will create a more fair competitive environment for small and medium-sized enterprises.

Q: In terms of search growth, I think there are some concerns about using competitive AI tools as alternative tools for search. With the development of this year and more innovative search experiences, have you seen any changes in query volume, whether positive or negative? What can truly set Alphabet-C apart from other AI tools in competition?A: First of all, when considering the impact on search, we need to take a broader perspective. People have many choices for information sources, and user expectations are constantly changing. I believe that continuous innovation is ultimately important. While AI generation is indeed a new tool, there is still much more to be done in terms of search functionality: breadth, depth, diversity in vertical fields, and stability. It involves accessing a rich variety of content sources on the web and integrating them in a suitable way.

In the second year, I believe our focus in testing is mainly on the search generation experience. We can see the progress we are making and how many users prefer this experience. I feel good about this progress. Our 24-year roadmap focuses not only on search functionality but also on potential AI advancements, including AI models. So I am very excited about the future of the next 24 years.

Q: Capital expenditure is $11 billion, showing growth. Are there any one-time projects included? What expectations do we have for 2024?

A: As I mentioned, the majority of the $11 billion capital expenditure in the fourth quarter is investment in our technical infrastructure. There are no one-time projects, and it truly reflects our outlook on everything Sundar, Philipp, and I have been talking about. The extraordinary applications of AI in Alphabet-C DeepMind, Alphabet-C Services, and Alphabet-C Cloud are comprehensive for users, advertisers, developers, cloud enterprise customers, and governments. This is indeed a long-term opportunity.

Therefore, last quarter, we did indicate that capital expenditure will continue to grow in 2024, and we do expect full-year capital expenditure in 2024 to be significantly higher than in 2023. Please note, and I think you all know this, the timing of cash payments can impact quarterly capital expenditure figures, but the key point is that we will continue to invest.

Q: In a document disclosed by Alphabet-C in the fall, it was stated that achieving a 20% RPM growth in search through the advertising quality team is a fragile strategy. Looking back to 2019, since then, your business has more than doubled. So I'm wondering, what is your view on Alphabet-C's ability to drive search RPM forward? And in terms of the massive revenue base that Ruth mentioned tonight, what are your thoughts on commercialization?

A: I have great confidence in the quality of our work. Whether it's search quality, ad quality, our improvements to search, or our improvements to ad RPM, all the fundamental pillars are very focused on ad quality so that we can provide real ROI for advertisers and improve the user experience. All of this is built on rigor, technical excellence, and market entry excellence, so the fundamental attributes will not change. I believe AI presents us with opportunities, and we are still in the early stages. In the long run, we will be able to meet information needs in a more profound way. From a long-term perspective, I am very excited about the future.Q: Regarding Alphabet-C Cloud, there has been fluctuation in business performance, from substantial deceleration in the previous quarter to acceleration in this quarter. Can this be explained by our position in the optimization cycle, meaning that workloads for generative AI are slowly flowing in, causing the growth curve to rise again? Do you have any comments on the fluctuations, deceleration, and re-acceleration we have observed?

A: It's a combination of various factors. I am very excited about our AI solutions, which are our foundation, but AI is undoubtedly something that generates interest and early adoption. As you can see, over 70% of generative AI organizations are using Alphabet-C Cloud, so I believe our advantage in this field will continue to play a role in 2024, especially when I see our innovations in AI. Secondly, I believe there are regional differences, but we have already achieved cost optimization in many aspects, which is also a contributing factor.

Q: I would like to ask about YouTube, advertising, and creativity, using AI to enhance creativity and truly provide performance-based video ad services created by AI for small and medium-sized businesses that have been working with Alphabet-C. Is this a new growth area? How far have you progressed in launching this product to the market? Do you think this opens up a new consumer field that did not exist before?

A: YouTube enables millions of creators around the world to share their voices, connect with audiences, and build thriving businesses, and AI has become a crucial part of it. As stated in the announcement released by YouTube, we have introduced many new complementary creative features on YouTube, such as Dream Screen, as well as many other interesting tools and ideas. It is evident that we can now apply it more actively to the advertising industry, and it continues to assist in AI, many of our video ad solutions, and measurement capabilities. It is part of making video-rich experiences. In fact, there are already generative music creation tools that make it easier for creators to design perfect soundtracks.

As I mentioned before, AI will open up a creative new world. If you look at the development direction of models, the trend of multimodal models, and the development direction of the generative capabilities of these models, you can definitely see how it will positively impact and simplify the creative process for creators, as you can see in some of our core products, such as ACA on the search side.

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