Google's third-quarter earnings report is generally positive, but the growth rate of its cloud business has slowed to 22%, which is lower than expected. As a result, the stock fell 6% after hours.

After the US stock market closed on Tuesday, October 24th, digital advertising and search giant Alphabet, the parent company of Google, released its third-quarter earnings report for 2023.

Although the overall revenue and profits for the third quarter were better than expected, Google Cloud's revenue fell short of expectations, causing the stock price to drop more than 6% after hours. Google Class A shares rose 1.7% on Tuesday, nearly erasing the decline since last Tuesday.

Excluding the after-hours decline on Tuesday, the stock has risen by about 12% since the announcement of its second-quarter earnings at the end of July, outperforming the cumulative decline of 7.5% in the S&P 500 index during the same period. Google, which has risen by 57%, is also one of the best-performing large-cap tech stocks this year, while the S&P has risen by more than 10% and the Nasdaq has risen by more than 25%.

Google's revenue returns to double-digit YoY growth after more than a year, but capital expenditure and operating profit margin fall short of expectations

The financial report shows that Alphabet's total revenue for the third quarter was $76.69 billion, an increase of 11% YoY, higher than the market's expected $75.8 billion. Adjusted earnings per share were $1.55, a 46% increase from the same period last year's $1.06, and higher than the expected $1.45.

However, operating profit was $21.34 billion, a YoY increase of over 24%, slightly lower than the expected $21.44 billion. The operating profit margin was 28%, also lower than the expected 28.1%, and higher than the 25% in the same period last year. Capital expenditure was $8.06 billion, lower than the expected $8.81 billion.

This is the first time in over a year that Google's total revenue has returned to double-digit YoY growth, after four consecutive quarters of decline to single-digit percentages. Google attributed this to significant growth in advertising revenue from search and YouTube, as well as momentum in its cloud business, and stated that it will "continue to focus on prudent capital allocation to achieve sustainable financial value."

In the quarter, Google's traffic acquisition costs (TAC) paid to partners were $12.64 billion, roughly in line with expectations. Revenue, excluding TAC that affects profits, was $64.05 billion, exceeding the expected $63.04 billion.

Cloud revenue, the most important after the emergence of generative AI, increased by 22% YoY, continuing to grow but at a slower pace and falling short of expectations, but turned a loss into a profit

Looking at the business segments, the cloud business, which is considered by the market as Google's next growth engine, had revenue of $8.41 billion in the third quarter, about $200 million lower than the expected $8.64 billion, but a YoY increase of 22% from $6.9 billion in the same period last year, which is twice the overall revenue growth rate of the company. This indicates that the YoY growth rate of Google Cloud revenue is slowing down. In the third quarter of last year, cloud revenue grew by 37.6% YoY, and in the fourth quarter, it grew by 32%. In the first and second quarters of this year, it grew by 28%.

At the same time, the operating profit of the cloud business was $266 million, lower than the market expectation of $433.6 million, but it has turned losses into profits compared to the operating loss of $440 million in the same period last year.

Google, ranked third in cloud computing market share, is still striving to catch up with competitors Amazon and Microsoft. Google Cloud includes the Google Cloud Platform (GCP), which provides infrastructure and data analysis platforms for enterprise customers, as well as productivity and collaboration tools (Google Workspace). Its share of total revenue has been hovering around 10%, still lagging behind the cloud leader Microsoft.

Some analysts also believe that Google Cloud is a key investment area for the company, and with the emergence of generative AI, this business has become more important as more companies turn to public clouds to run heavy workloads.

However, Evercore ISI pointed out that channel checks "indicate that cloud spending is picking up," partly due to increased demand for AI, and he expects cloud spending to further accelerate by 2024. Google's strong position in generative AI software is a competitive advantage for its cloud business.

Google's core advertising revenue exceeds expectations, showing a healthy digital advertising market since negative growth in the fourth quarter of last year

The core advertising business is also Google's main revenue driver closely watched by Wall Street. Advertising revenue in the third quarter was $59.65 billion, higher than the market expectation of $58.94 billion, an increase of 9.5% YoY.

Among them, advertising revenue from the YouTube video platform was $7.95 billion, an increase of over 12% YoY, higher than the expected $7.8 billion. Google's search and other advertising revenue increased by over 11% YoY to $44.03 billion.

This marks a steady improvement in its advertising revenue. Due to the economic downturn last year and increased competition from TikTok, Google's core advertising business weakened. However, since the announcement of negative growth in the fourth quarter of last year, advertising revenue has been slowly improving.

Alphabet CEO Sundar Pichai said during the earnings conference call that YouTube Shorts, which competes directly with short video platform TikTok, has reached 70 billion daily views, compared to over 50 billion daily views at the beginning of the year.

Some analysts point out that Google's earnings report will be the first comprehensive examination of the health of the digital advertising market in the third quarter. Google and its competitor Meta are seen as leaders in the industry, and any negative performance could have a significant impact on the stock prices of other digital advertising companies. However, Evercore ISI analyst Mark Mahaney said that the "advertising spending environment has moderately improved," and Wedbush analyst Scott Devitt also believes that the situation for digital advertising in the second half of the year remains optimistic, with the growth rate continuing to accelerate.

Innovative business revenue increased by 42% YoY, but still incurred a loss of nearly $1.2 billion, executives admit that customer cloud spending has declined

"Other Bets" was once Google's technology innovation department, focusing on forward-looking product development and venture capital investment, including autonomous driving startup Waymo, intelligent healthcare Verily, venture capital fund Google Capital, and Google Ventures, etc.

In the third quarter of this year, this business generated revenue of $297 million, a year-on-year increase of 42%, exceeding the expected $259 million; operating losses were $1.19 billion, slightly narrower than the loss of $1.23 billion in the same period last year and the expected loss of $1.2 billion.

CEO Sundar Pichai said that the momentum of the products in the third quarter was strong, driven by the artificial intelligence innovation of businesses such as search, YouTube, cloud, and Pixel hardware devices. "The company continues to be committed to providing more assistance to everyone through artificial intelligence, and there will be more progress in the future."

Ruth Porat, who transferred from CFO to President and Chief Investment Officer of the company on September 1st, stated that the growth of the cloud business "remains strong in various regions, industries, and products," but the slowdown in growth reflects the "impact of customer optimization work."

Some analysts believe that this term usually refers to a decrease in customer cloud spending. Pichai said during the conference call that Google currently "tends to help customers (optimize cloud spending) because customers are facing some other challenges."

He also stated:

The company is passionate and confident about the opportunities in the field of artificial intelligence. Satisfied with the growth prospects of YouTube's short video business.

Restructuring the expenditure base in order to make more investments. The cloud business for AI startups has growth momentum.

Satisfied with the feedback received in the experimental research field. The transformation to artificial intelligence is comparable to the transition from desktop devices to mobile terminals in previous years.

The company will make every necessary effort to maintain a leading position in the field of artificial intelligence.

Investors also want to know whether AI investments can bring incremental revenue to the company's cloud and enterprise businesses, and how they will affect costs. In the second quarter, Google stated that the growth in demand for artificial intelligence will drive an increase in infrastructure costs in the second half of 2023 and 2024.

Previous analysis pointed out that generative artificial intelligence can provide more creative and comprehensive answers for simple text queries. If people change the way they search for information online because of this, it may have a significant impact on Google's core search and advertising businesses.

Google's Q3 Employee Reduction of Approximately 4,000, Besides Heavily Investing in AI, It Also Faces a Series of Global Regulatory Challenges

This year, Google has made significant investments in artificial intelligence (AI) in an attempt to catch up with Microsoft's investment in OpenAI and gain a first-mover advantage.

Among these investments is the launch of Bard, a chatbot competitor to OpenAI's ChatGPT, which incorporates generative AI technology into more of Google's consumer and enterprise products. Google has also been testing this technology in its core search business, aiming to regain its position as the leader in AI in Silicon Valley. In early October, Google released its latest flagship smartphone, which features AI capabilities and includes basic AI models.

During the third quarter, the company underwent management restructuring and layoffs across its entire business organization, including its news division, autonomous driving department Waymo, and recruitment agency. According to the earnings report, the total number of employees decreased by approximately 4,000 to 182,400 at the end of the third quarter.

Currently, Google is facing a series of regulatory issues.

The U.S. Department of Justice has filed two antitrust lawsuits, accusing the company of abusing its power by signing restrictive default device contracts and distorting competition in the online search engine and digital advertising markets. The European Commission is also working to break up Google's advertising business. The Japanese antitrust regulatory agency is investigating whether Google has been pressuring smartphone manufacturers to favor its search products and suppress competition.

Wall Street is Optimistic about Google's Advertising Revenue Recovery and the Boost from AI to its Search Business, but Some are Cautious about Changes in the Search Market

Ahead of the earnings report, Wall Street generally maintained buy or hold ratings, with Deutsche Bank raising its target price, suggesting a 7% upside potential. The optimism stems from the recovery of the advertising business, as well as the acceleration of Google's core search business due to investments in AI. Bank of America stated:

"As advertisers increasingly adopt maximized advertising strategies and the popularity of AI-driven products such as dynamic keyword ads grows, AI will have an increasingly positive impact on Google's advertising sales in the second half of 2023.

We expect Google's core business to demonstrate strong profit leverage in the second half of this year, driven by accelerated search growth, and cost efficiency in 2024 may lead to upward revisions of Wall Street's forecasts.

The next major event could be the launch of Gemini, which is expected to have outstanding performance in large language models and contribute to the development of Google's AI business."

However, Wells Fargo Bank has a more conservative forecast for 2024, reiterating a "market perform" rating. Although it raised the target price by $5 to $126, it still implies a 7% decline from Monday's closing price. The reason for this is:

"The upcoming transition to conversational search formats will bring significant uncertainty to the search market. We expect this format change to cause disruptions and potentially hinder Google's mid-term search growth." At the same time, competitors may actively bid for Google's search distribution partnerships, thereby reducing Google's profitability. Even if Google maintains its leading position in search, we do not expect the company to replicate its past prosperity in the next decade.