Google: Is the little ghost haunting? AI solves a thousand worries

After the market closed on October 29th Eastern Time, Google's parent company $Alphabet(GOOGL.US)$Alphabet-C(GOOG.US) released its financial report for the third quarter of 2024. The resilience of the U.S. economy in the third quarter was strong enough, coupled with a concentration of events such as the Olympics, the European Cup, the Copa America, and the increase in political advertising brought by the U.S. presidential election, driving the overall industry's advertising demand beyond what Dolphin Jun had previously expected. As the leader in advertising, Google naturally benefited from this.

With a stable advertising foundation, Google can expect growth in cloud services under the AI wave, as well as improving overall profitability through the integration of internal resources by large companies.

In addition to the current performance, many investors are paying more attention to the "little demons" that Google has been entangled with recently. Therefore, while interpreting the performance, Dolphin Jun also discusses Google's antitrust lawsuit, the impact of AI on search, and competition among peers.

Specifically, looking at the core information:

1. Search fundamentals remain stable: Search's steady growth is somewhat expected, partly based on the stable market share of Chrome; on the other hand, it is still being driven by PMax and Ad Manage tools integrated with AI. In addition to internal factors, sectors such as finance and automotive that are relatively benefited by interest rate cuts have increased their advertising spending, which is often an area of strength for search advertising.

2. Cloud business significantly exceeds expectations: Benefiting from AI demand, cloud revenue accelerated by 35% in the third quarter. Although the base of the third quarter of last year was relatively low, the quarter-on-quarter growth rate still accelerated, significantly exceeding the market's expected 29% year-on-year growth rate.

The prosperity of the third quarter is actually traceable. Google's backlog of contract sizes increased by 30% year-on-year in the previous quarter, also showing an accelerating trend. The additional contract value calculated by Dolphin Jun also reached 16.7 billion, doubling that of the previous quarter. Although there are fluctuations due to seasonal effects, the upward trend in prosperity is undeniable.

3. YouTube advertising without surprises: YouTube, which disappointed in the previous quarter, did not drag behind further in the third quarter, thanks to the promotion of the Olympics and political advertising for the presidential election, but it also did not exceed expectations.

In terms of core logic, YouTube still faces internal erosion issues after the increase in Shorts traffic share in the short term, as well as competition in CTV advertising from new competitors such as Netflix and Amazon PrimeThe shift in cross-border e-commerce user targeting strategy (from omni-channel to focusing on social platforms) has led to a slowdown in advertising placements on YouTube, which has also dragged down YouTube's ad performance.

Ultimately, it still boils down to product competitiveness (including the level of product technology, functionality, and suitability for use scenarios). If Shorts has a better ROI effect, advertisers will not allocate more budget to Reels.

4. Reversal of Other Revenue Growth: In the third quarter, the growth rate of other revenue rebounded to 28%, reversing the continuous slowdown trend of the previous quarters. The growth was mainly driven by YouTube subscriptions and the Pixel 9 series phones that just launched in the third quarter, which include Gemini Nano. However, in the fourth quarter, without this hardware increment, the growth rate may return to its original trend.

5. Capital Expenditure Maintains High Levels, but Profits Rise Against the Trend

In the third quarter, the operating profit margin was able to stay at a high level, mainly due to a stable increase of 0.4 percentage points in gross profit margin compared to the previous quarter, and a 2 percentage point increase year-on-year, with operating expenses fluctuating slightly. Research and development expenses saw a slight slowdown in growth, management expenses decreased by 10% year-on-year, and although sales expenses returned to positive growth, it was only a slight increase of 5%.

Looking at the operating profit margin levels of Google's service department and cloud business department, both exceeded market expectations in the third quarter, with the cloud business department showing a significant increase of 6% compared to the previous quarter. This indicates that the main business departments are more efficient than the headquarters. Recently, Google has been involved in many lawsuits, and the headquarters expenses may include increased legal expenses.

However, the market's script was not originally written this way, but rather with the expectation of a weakening profit margin on a quarter-on-quarter basis under the high Capex expectations of "prefer to over-invest, rather than under-invest" and the guidance of net employee additions. Dolphin believes that the difference in expectations here may come from the improvement in internal operational efficiency, such as team integration (previously reported news of the Gemini team merging into DeepMind), resource reuse, and AI optimizing the internal basic technology costs.

However, considering that capital expenditure in the third quarter remained at a high level of 13.1 billion, a year-on-year increase of 62%, it is worth paying attention to the company's explanations during the conference call, specific measures to drive internal efficiency, and the company's guidance on future Capex and profit margin.

6. Two Major Lawsuits Advancing in Parallel, Is Google Going to Be Dismantled?

This point also requires attention to the statements during the conference call, as there was no disclosure of information in the financial report. However, with the details of the federal court's remedial plan about to be released, and the judgment on the anti-competitive lawsuit against Ad-tech expected before the end of the year, it is difficult for recent transactions to avoid this disruptive factor.

In the following text, Dolphin will provide a detailed analysis. Overall, the likelihood of the implementation of potential breakup measures against Google in the two lawsuits is very low, but if other remedial measures are directly implemented, the impact on Google will not be insignificant. It is recommended to pay attention to the key timelines following the lawsuits.

7. Stable realization of shareholder returns

At the beginning of the year, Google announced a gift package of an additional $70 billion buyback authorization + first dividend payout. In the third quarter, it actually repurchased $15.3 billion and distributed $2.3 billion in dividends. Over the past 12 months, shareholder returns have accumulated to $70 billion. Dolphin estimates roughly that based on this buyback and dividend distribution pace, the expected annualized return on buybacks + dividends is 3-4%.

8. Key indicators and comparison with expectations

Dolphin's viewpoint

Due to the impact of trends such as anti-competitive lawsuits and AI investment expansion leading to the suspension of efficiency improvement, since the disclosure of the second-quarter report, Google's valuation has been significantly suppressed, lagging behind the index and the performance of Big Tech peers. For example, in terms of profit growth expectations, Google is not much worse than Meta, but the market trades Google around 19x Forward P/E, while Meta trades around 25x, not to mention the higher valuations of Microsoft and Apple.

The third-quarter report has somewhat alleviated the concerns about the impact on profitability in the short term. If the current level of profit margin can be maintained, that is, if AI's significant role in internal efficiency improvement as stated by management is true, rather than a temporary increase caused by the disturbance from capital investment to actual operating expenses confirmation, then at least from a valuation perspective, there is hope for a wave of recovery, such as rising from 19x to a normal central level of 23x. This can be observed in the conference call, in the management's related answers.

However, Dolphin believes that in addition to ongoing litigation issues in the next year, the third-quarter report has not dispelled some potential negative impacts in the medium to long term:

For example, the shift in consumption habits of the new generation of users from search to social media preferences? Will Google's traffic face losses during the process of AI search replacing traditional search? Will the commercialization of AI Overview erode traditional search and alliance advertising revenue? If Trump returns to office, will TikTok make a comeback, thereby reclaiming some of the market share eaten up by Shorts and Meta's Reels?

The existence of these issues is a key obstacle for Google to continue to rise from the central valuation and narrow the valuation gap with other Mag 7 giants. Of course, disruption does not happen overnight, and advertising is not solely determined by traffic, but also relies on the underlying business ecosystem. Therefore, as an investor, it is necessary to constantly focus on Google's more technological innovations in AI, product feedback, and whether it can launch a mature business model that fits the logic of AI entry, to achieve true transformation at a lower internal erosion cost.

Below is a detailed interpretation of the financial report

I. Introduction to Google

Google's parent company Alphabet has a wide range of businesses, and its financial report structure has changed multiple times. For those who are not familiar with Alphabet, you can first take a look at its business structure

Briefly explain the long logic of Google's fundamentals:

a. The advertising business, as the main revenue source, contributes the majority of the company's profits. The crisis of search advertising being eroded by feed ads in the medium to long term is being addressed by the high-growth streaming platform YouTube.

b. The cloud business is the company's second growth curve, having turned losses into profits and showing strong recent momentum in contract signings over the past year. As advertising continues to be dragged down by weak consumer spending, the development of the cloud business is becoming increasingly important in supporting the company's performance and valuation prospects.

II. Revenue: Stable advertising foundation, subscriptions and cloud services exceeding expectations

In the third quarter, Google's overall revenue was $88.27 billion, a 15% year-on-year increase, exceeding market expectations.

The core pillar, the advertising business, which accounts for nearly 80% of the revenue, grew by 10.4% year-on-year, driven by the resilience of the U.S. economy in the third quarter, coupled with events such as the Olympics, UEFA Euro, Copa America, etc., boosting overall industry demand for advertising. As the leader in advertising, Google naturally benefited.

Beyond advertising, AI is driving Google Cloud services to continue accelerating high growth at 35%, significantly exceeding market expectations. Additionally, revenue growth exceeding expectations is also contributed by other sources such as YouTube subscriptions.

Specifically:

(1) Advertising: Overall expectations met, search and affiliate ads slightly exceed expectations

In the third quarter, advertising revenue was $65.9 billion, a 10.4% overall increase, with growth slightly slowing compared to the second quarter due to the impact of high base numbers brought by cross-border e-commerce advertising in China in Q2 last year. Overall, institutional expectations were relatively well met due to the resilience of macro data and positive feedback from advertising experts. Looking into details, search was strong, YouTube was stable, and affiliate ads exceeded market conservative expectations.

a. Search Advertising

In the third quarter, Google's search revenue reached $49.4 billion, a year-on-year increase of 12%. The steady market for search has long been anticipated:

(1) On one hand, this is based on the relatively stable Chrome traffic share. Although ChatGPT and Microsoft's New Bing are continuously penetrating users, it is still difficult to shake Google's absolute monopoly position. In addition, in May, Google launched the AI search feature SGE (later renamed AI Overview) integrated with the Gemini large model, promptly meeting the demand for AI functions. As a result, the motivation for users to migrate elsewhere in the general search scenario is lower. In a situation where there is no traffic advantage and the corresponding advertising ecosystem has not been established, the likelihood of advertisers' budgets shifting significantly in the short term is very low.

(2) Another factor contributing to the stable growth of search in the short term is that PMax and Demand Gen tools, integrated with AI, can provide advertisers with low-cost marketing services and higher ROI placement effects.

For example, in the previous quarter's conference call, the management mentioned that AI-driven profit optimization tools expanded to Performance Max and standard shopping ad series, resulting in an average profit increase of 15%. When Demand Gen is used in combination with search or PMax, it brings an average conversion rate increase of 14%.

(3) In addition to internal factors, the overall industry in the third quarter, especially in retail, has shown strong growth. Sectors such as financial services and automobiles, which are relatively benefited under the expectation of interest rate cuts, have also increased their advertising spending. These types of advertisers are often important customers of search advertising, thus providing more momentum for the short-term growth of search advertising.

However, despite the presence of AI Overview, competition and the relentless pursuit of federal courts make Google not completely worry-free:

In terms of competition, new AI forces such as OpenAI and Perplexity are developing search engines, while Big Tech companies like Apple and Meta have recently been reported to be secretly developing their own internal search engines. Apple is more inclined to empower search with AI for functional updates, while Meta mainly aims to provide users with query and information retrieval functions through front-end AI assistants.

Regardless of the product form, for users, these products actually provide functionalities that are similar to or can substitute for Google search.

In the anti-competitive litigation in court, what is directly related to search is mainly the progress of litigation on search commercial contracts, which is also one of the core factors under valuation pressure. This is a trial brought by the federal court against Google for anti-competitive behavior in obtaining default search engine effects on other Android device platforms such as Apple and Samsung by paying a "traffic fee" to the platform (included in TAC costs).

According to the evidence related to the litigation, in 2021, Google paid third parties such as Apple a "traffic fee" of $26.3 billion, accounting for 58% of the overall TAC costs that year and 10% of total revenue.

The August judgment revealed that potential rectification measures may also include consideration of splitting the Android system, causing concerns among many investors. The possibility of a split is still considered low by Dolphin, with many points of appeal available to Google similar to Microsoft in the past. However, it is highly likely that the rectification plan requiring Google to abandon the "default operation" will be implemented.

In response to this, some institutions have made some expectations, generally believing that in Google's search revenue, assuming 40% comes from the United States, 50-55% of mobile revenue is related to the "default search engine" operation on mobile mentioned above. Although Google's search engine product still leads the industry, it must be acknowledged that the "default operation" is quite helpful in shaping user usage scenarios. Otherwise, Microsoft would not actively participate in the hearing and strive to make Google lose this lawsuit.

Therefore, if the "default operation" is canceled, it means that the 20% of search revenue from the above calculation will face a short-term impact of loss due to reduced user usage. However, Dolphin believes that if users are given a relatively fair choice, the number of users who truly abandon Google and choose other search engines may be minimal.

For example, based on the current PC search engine market share, an 80% market share for Google means that the proportion at risk of loss is 20% * (1-80%) = 4%. Of course, if mobile phone manufacturers such as Apple give higher guidance and recommendation weight to their own search engines, for example, if Google's market share on mobile drops below 50%, the proportion of revenue loss will be 20% * (1-50%) = 10%. In the latter assumption, the short-term impact on Google is still significant, but in the medium to long term, it still needs to compete based on product strength.

In addition to the framework of abandoning the "default operation" commercial contracts and the "user choice" framework, the federal court proposed other rectification measures for Google's search monopoly position on October 8 (prohibition of anti-competition, fair access, data sharing). In terms of specific implementation details, Dolphin speculates that it may be necessary for Google to share user data from its search platform with competitors, restrict Google from using platform search data to train AI, and limit Google's business cooperation with some distributors, and so on.

These rectification measures are clearly unfavorable to Google. Google made a relatively brief response to this in early October. At the end of November, the federal court will provide specific rectification measuresGoogle is expected to respond to the federal court's rectification measures next year.

b. YouTube Advertising

YouTube, which performed disappointingly last quarter, did not continue to lag behind this time, but also did not bring any surprises. In the third quarter, it achieved advertising revenue of 8.92 billion, a year-on-year increase of 12%, in line with expectations.

Regarding the recent weaker performance of YouTube in the past few quarters, Dolphin Jun also provided a simple explanation and analysis in the last quarter's financial report interpretation. Here, let's discuss it again in light of recent changes.

Although traffic on YouTube's mobile end is increasing, and YouTube TV's viewership share in the television market is gradually increasing, internally, traffic is leaning towards Shorts. This is influenced by user habits and the company's guidance.

However, the ROI effect of Shorts is currently not as good as Meta's Reels, and in reference to Reels' advertising unit price, the overall CPM quotation for short videos is still significantly lower than traditional feed ads (such as Meta's Feeds, although Reels is narrowing the price gap with Stories), not to mention the in-video ads inserted in YouTube content. Therefore, as the budget proportion of Shorts increases, it can be expected that YouTube's overall CPM quotation will be under some pressure in the short term.

In addition to internal erosion issues, although YouTube can also be classified as a social platform, brand advertising accounts for a considerable proportion. However, this year, due to AI technology improving the impact of Apple's privacy policy on performance advertising, part of the advertising budget has shifted back from brand advertising to performance advertising. In addition, with Chinese cross-border e-commerce shifting from all channels to focusing on social platforms overseas, and last year was a period of crazy advertising spending, the high base number combined with the contraction of advertising channels itself has brought some drag on YouTube's growth.

Furthermore, YouTube TV may also be affected by Netflix and Amazon Prime. Although YouTube TV continues to have an advantage in viewership share, Netflix and Amazon Prime TV did not formally promote commercialization through advertising until this year, so there was no competition in advertising before. However, now YouTube TV also needs to be prepared to deal with this.

However, sports events such as the Olympics in the third quarter, as well as political advertising such as the U.S. election, are estimated to have helped recover some share of brand advertising. It is expected that in the fourth quarter, due to the U.S. election, the short-term political advertising on YouTube will increase, helping to alleviate the growth pressure on YouTube.

c. Network Alliance Advertising

Although network alliance advertising revenue was still declining by 1.6% in the third quarter, both in terms of trends and market expectations, it is actually showing signs of recovery. This should be attributed to the adjustment action of temporarily postponing the abandonment of third-party cookies proposed by the company last quarterPreviously, in order to protect user privacy, Google originally planned to completely abandon third-party cookies in the third quarter. The restriction on third-party cookies has caused significant challenges for ad distributors in tracking and targeting user data, leading many advertisers to shift their budgets early.

However, alliance advertising faces another pressure as Google introduces AI search features to counter the competition from new AI forces in traditional search scenarios, aiming to enhance user experience with new technology. For platforms relying on Google for ad distribution, the AI search question and answer feature provides a curated version of the best answers, eliminating the process of users clicking on links to redirect. As a result, distributors experience a significant reduction in effective user clicks and behavioral data, impacting the effectiveness of ad placements for distributors.

For example, the chart below shows the short-term traffic impact on websites in different fields after the introduction of SGE:

In this scenario, end advertisers will also shift some of their budgets to trackable and targetable ad platforms, such as Google Search itself or other leading platforms. Until the commercial gap created by the introduction of AI search is balanced and filled, budgets in this area will inevitably be migrated, thus affecting the scale of alliance advertising revenue.

However, for Google itself, the alliance advertising business, which accounts for 9% of revenue, does not have a high profit margin as most of the revenue is shared with external ad distribution platforms. It is expected to be in the high single digits, and according to market expectations for 2024, alliance advertising contributes 2% to the overall company's operating profit, making the financial impact relatively manageable in theory.

However, the alliance advertising business is currently related to the antitrust lawsuit Google is facing. The point of contention in the federal court dispute is:

In the digital advertising industry chain, Google provides a publisher platform, Doubleclick for Publishers, to collect inventory information from upstream ad suppliers; at the same time, Google provides an Ad Exchange platform to collect ad demand from downstream ad buyers and match transactions.

When collecting ad demand from downstream advertisers, Google operates with two identities. One is to collect demand and quote for its own platforms such as Chrome, YouTube, Mail, Map, etc., and the other is to provide Display & Video 360 and other DSP platforms to cooperative ad distributors to collect advertiser demands.

Due to the fact that both the publisher platform Doubleclick and the demand platform DV360 have a considerable market share (90%/40%), the federal court reasonably suspects that Google adjusts its own pricing by comparing the prices of other ad distribution platforms and may even intervene directly in the cooperation between advertisers and platforms that are in competition with each other during the actual matching process in AdExchange.

Therefore, the U.S. federal court has requested the divestiture of Google AdExchange or DV&360. While the operating profit contributed by these two products to Google as a whole is relatively limited, the key point is that Google obtains advertising data internally from these two products, which may help Google maintain competitiveness in its own products.

Currently, the federal court intends to make a ruling by the end of this year. However, if Google does not accept it, further steps such as hearings and appeals will be necessary. The sudden push for this lawsuit this year is not a sudden decision by the federal court, but rather a recurring topic that has been investigated as early as 2021, but was inconclusive at that time.

Dolphin believes that even if the anti-competitive behavior is confirmed, it will be quite challenging to implement the proposed split. It is more likely that there will be increased requirements for information disclosure and fair trade in Google's advertising trading platform.

(2) Cloud: Significantly Exceeding Expectations!

In the third quarter, the overall revenue of the cloud service department reached 11.35 billion, with a year-on-year growth rate of 35%, showing a significant acceleration compared to the previous quarter, exceeding the market's expected growth of 29%. Although the base number from the same quarter last year was relatively low, the quarter-on-quarter growth rate still indicates a continued acceleration in the third quarter.

The cloud business clearly benefits from the revenue growth driven by AI. The company mentioned in the previous quarter that the revenue generated from the AI segment has reached a level of several billion, used by over 2 million developers. In addition, the CEO mentioned at a forum conference that the current demand for TPU and GPU from customers is very high, exceeding Google's current supply, and even leading to the rejection of some customer demands.

Furthermore, the high growth of the cloud department is still driven by Google Workspace,

The cloud business is B2B-oriented, so its long-term trend may be related to its own product competitiveness, but short-term changes are more likely to be influenced by changes in the scale of new contracts in the current or previous period.

Therefore, Dolphin generally uses Google's Revenue Backlog indicator to assess short-term trends. This indicator is mostly derived from the cloud business, so its trend can also be seen as the trend of the unfulfilled contract volume of the cloud business.

Based on the contract scale, there can be some expectations for the prosperity of the cloud business in the third quarter. As of the second quarter (data for the third quarter needs to be found in the complete quarterly report submitted to the SEC, although the data is lagging, the overall trend can still be seen), Google Cloud's backlog contract scale reached 78.8 billion, with a year-on-year growth of 30%, showing a significant acceleration on a quarterly basisDolphin estimates a net increase in contracts of 16.7 billion, which is significantly higher than the 8 billion in the first quarter.

Regarding the backlog of contracts in the third quarter, Dolphin will update the detailed data module on the Changqiao app promptly after the complete financial report is disclosed. If interested, you can follow it.

(3) Other Businesses: YouTube Subscriptions or Merits

Other income in the third quarter also significantly exceeded expectations, reaching 10.7 billion in revenue, a 28% year-on-year increase, with an accelerating trend on a quarter-on-quarter basis. This part of the revenue is mainly composed of YouTube subscriptions (TV, music, etc.), Google Play, Google, One, hardware (Pixel phones and smart home appliances Nest), and others.

Dolphin believes that based on the deliberately disclosed data in the company's financial reports for the past four quarters, the total revenue from YouTube advertising + subscriptions reaching the milestone of 500 billion, the growth support for other income in the third quarter may still be in line with the intentions of the previous two quarters, mainly driven by YouTube subscriptions. In addition, the release of the Pixel 9 in the third quarter also contributed.

In the second quarter of last year, YouTube raised its membership fees, but TV viewership shares continued to rise steadily, thereby driving subscription revenue growth. However, the base dividend brought by the price increase ended after the second quarter. Dolphin originally thought there would be pressure in the second half of the year, but of course, the impact of this election on user viewing demand cannot be ruled out.

III. Capital Expenditure Maintains High Levels, But Profit Margins Remain Unaffected

The operating profit of the core business in the third quarter was 28.5 billion, a 34% year-on-year increase, with a profit margin of 32.3%, stable on a quarter-on-quarter basis, exceeding market expectations by 7%. GAAP net profit beat more, but mainly driven by investment income. Dolphin generally only focuses on the operating situation of the core business, which is the operating profit indicator.

Overall, the operating profit margin can be maintained at a high level mainly due to the stable increase of 0.4 percentage points in gross profit margin on a quarter-on-quarter basis and a 2 percentage point increase year-on-year, with operating expenses fluctuating slightly. Among them, the growth rate of research and development expenses has slowed slightly, management expenses have declined by 10% year-on-year, and although sales expenses have returned to positive growth, it is also a slight increase of 5%

Looking at the operating profit margins of Google's service department and cloud business department alone, both exceeded market expectations in the third quarter. In particular, the cloud business department saw a counter-trend increase, with a 6 percentage point increase compared to the previous period, indicating that the main business departments are more efficient than the headquarters. Recently, Google has been involved in multiple lawsuits, and the headquarters expenses may include increased legal expenses.

However, the market's original expectation was that, based on the confirmation of incremental costs related to AI investment and the management's guidance on quarter-on-quarter growth in employee scale from the previous quarter, the operating profit margin in the third quarter was expected to decrease by 2 percentage points to 30%.

In reality, Google did indeed add net new employees in the third quarter, but the increase was not significant, and the total number of employees compared to the same period last year still decreased. The growth rate of research and development expenses slightly slowed down, sales expenses increased slightly, and management expenses continued to decrease by nearly 10% year-on-year. This ultimately maintained the operating profit margin at 32%, with Google's service profit margin also maintained at 40%, while the cloud service operating profit margin significantly improved to 17%, a 6 percentage point increase compared to the previous period, whereas the market originally expected it to remain flat.

In the short term, the counter-trend improvement in cloud service profitability and the high service profit margin maintenance lead Dolphin to believe that to some extent, Google is benefiting from the AI transformation. However, it is also worth noting that the cost recognition of infrastructure related to AI may not have yet reached the small peak of investment starting from the fourth quarter of 2022.

Although from a medium to long-term perspective, Google's cloud service profit margin still lags behind Microsoft and Amazon by a significant margin, behind the short-term increase in profit margin, the overall company's operating expenses growth rate for Q3 slowed from 20% in Q2 to 15%, and the overall company's depreciation costs growth rate also showed a quarter-on-quarter slowdown, which seems somewhat contradictory to the trend of high capital expenditures since the beginning of this year:

Q3 capital expenditures remained at 13.1 billion, a 62% year-on-year increase, slightly exceeding market expectations. It is worth paying attention to the company's explanations during the conference call, whether the overall efficiency improvement was achieved through other means such as team integration, reuse of basic resources, and compression of administrative operating expenses, as well as the company's guidance on future Capex and profit margins.