Google: Decline Approaching, Ad Leader Has Fallen

Hello everyone, I'm Dolphin Analyst!

This morning, on October 26th Beijing time (October 25th US stock market after-hours), Google released its Q3 2022 financial report. Although Snap came up short first, this time, unlike Q2, the market didn't react immediately. Therefore, the Q3 report, which missed both revenue and earnings, greatly disappointed the market.

Details are as follows:

1. Revenue plummeted as advertising slammed on the brakes. Due to economic recession expectations, intensified competition, and the impact of Apple's IDFA policy on YouTube advertising, the pressure on Google's advertising business continued to grow, with overall growth falling to 3.3%, with YouTube advertising and affiliate advertising both declining except for search advertising maintaining a positive growth rate of 4.3%.

Although Google Cloud exceeded market expectations and grew faster, the total revenue only maintained a 6% growth rate, lower than the market expectation (YoY 9%), due to the drag of the advertising business, which accounts for nearly 80%, and the unfavorable impact of exchange rate changes on international revenue.

2. Expenses have not yet shrunk, and profit margins have dropped significantly. Although there were reports that Google has slowed down its recruitment considering macroeconomic headwinds, the Q3 financial report shows that there was no obvious shrinking, with the number of employees increasing by nearly 13,000 compared to the previous quarter, a YoY growth of 25%. While costs have increased slightly, the three operating expenses are still expanding at a high-speed rate.

As a result, both gross profit margin and operating profit margin fell significantly, but the main deterioration was on Google's service business, primarily based on advertising revenue, while the loss situation of Google Cloud is gradually improving.

3. In the shareholder letter, the management still doesn't have much to say about their performance, but a few points are worth noting:

(1) Excluding the impact of the US dollar appreciation, the revenue growth rate is at 11%.

(2) Currently focusing on using AI technology to improve search advertising and cloud services, as well as seeking to monetize YouTube Shorts.

(3) Adjusting resources to drive growth. During macroeconomic headwinds, the market may not be happy with Google's accelerated staff expansion, and this "adjusting resources" may indicate some personnel optimization or expenditure contraction.

Dolphin Analyst's Opinion

During economic downturns, advertising stocks are not ideal, especially in this highly uncertain period where multiple factors are at play this year. Although the recent economic figures over the past few months show that US consumer demand is still stronger than the market expected, advertising expectations are ahead of the curve, and the risk of a recession has caused advertisers to tighten their budgets in advance. Furthermore, outside of North America, where the macro environment is even worse, they contribute to more than 50% of Google's revenue, so the drag effect is also very apparent. Last quarter's "surprise" was more due to the market's short-term overreaction to panic after Snap's first-ever collapse this year. But Google's actual performance was not good, reflecting the fact that the economic environment has quickly turned cold, and this performance further confirms the consensus on economic recession.

As the largest advertising company, its formerly stable performance has been repeatedly broken in the challenging macroeconomic environment this year. Therefore, for this Q3 report, the market must intensify its concern about the future economic slowdown, further depressing Google's and other advertising stocks' growth expectations. Against this backdrop, Google's cost spending is still expanding against the trend, which is not what the market wants to see.

In addition, how much of the revenue decline is due to the impact of competition (such as TikTok), is something the management may need to answer in the conference call. Market judgement on whether Google will face further "performance killing" risks next year depends on the company's outlook on macroeconomic environment and revenue profit growth guidance when YouTube Shorts is commercially launched.

Later, Dolphin Analyst will share the conference call summary with Dolphin users through the Longbridge app. Interested users are welcome to add the WeChat account "dolphinR123" to join the Dolphin investment research group and get the conference call summary as soon as possible.

Detailed interpretation of this financial report

I. Basic Introduction of Google

Alphabet, Google's parent company, has multiple businesses, and its financial reporting structure has also changed several times. If you are not familiar with Alphabet, you can first look at its business architecture.

Briefly explain the long-term logic behind Google's fundamentals (there is a difference with the current short-term logic):

1. The advertising business, as the main source of revenue, contributes the company's main profit. Search advertising faces the crisis of being eroded by information flow advertising in the medium to long term and is perfectly complemented by high-growth streaming media YouTube.

2. The cloud business is the company's second growth curve, although it has not yet been profitable, but recently the momentum of signing contracts is strong. As advertising suffers from weak consumption, the development of cloud business is becoming increasingly important in supporting the company's performance and valuation imagination space.

II. Revenue: Advertisements significantly dragging, cloud business accelerating month-on-month

This time, due to the market's confidence in Google, it did not immediately adjust expectations in response to Snap's collapse, and the final performance was disappointing.

1. Q3's total revenue was US$69.1 billion, a year-on-year growth of 6.1%, significantly lower than the market's expected US$70.9 billion, and the good student image was broken.

2. The main reason for the rapid decline in ad revenue, which accounts for over 80% of the total, is due to YouTube and affiliate ad revenue both experiencing negative growth, while search ad revenue is achieving only marginal growth due to relatively robust service consumption and the benefits of the Apple IDFA policy, all three of which are falling short of the expectation of the bank.

Third-party data indicates that the proportion of television user time on YouTube is increasing, which means that the supply of ad inventory is not the problem, but the performance of the final revenue is poor, mainly affected by the decrease in CPM, which has been reflected in the trend of the first two quarters. A decrease in CPM is often related to the advertising needs of advertisers, which represents the expectation of business for the economic outlook is not optimistic.

Search ads have a certain relative advantage. On the one hand, the high service consumption is currently the main source of revenue for search ads. On the other hand, the hit of Apple IDFA is more significant for personalized information flow ads, so some businesses have reduced their advertising budget and turned to search ads with higher conversion rates.

However, search ads are also facing a situation where the advertising unit price is falling due to the reduction of marketing budgets by businesses. Although the relative advantage is still continuing, it is also rapidly exhausting.

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3. Cloud business exceeded expectations, with accelerated revenue growth and improved losses

The third quarter saw excellent performance in cloud business, with revenue reaching 6.87 billion USD, a YoY increase of 37.6%, slightly faster than the 35.6% growth seen in Q2. This high growth can be sustained even under the unified act of reducing capital expenditures in most technology companies, mainly due to the technical and product strength improvements of Google Cloud, as well as its advantages in the consumer industry. It is also possible that it is primarily due to the consumption of contractual balances (this needs to be confirmed in conjunction with the data disclosed in the complete quarterly report).

Since signing several long-term cooperation contracts with major clients in the fourth quarter of last year, the growth rate of contractual balances waiting to be executed by Google Cloud (latest data as of 2022 Q2) has slowed down considerably. However, due to the high growth rate of cloud revenue confirmed every quarter, especially in the current environment, this suggests that the product competitiveness of Google Cloud is not weak.

However, Dolphin Analyst still needs to mention the future risks. Under economic pressure, in addition to the difficulty of expanding new customers, existing customers may also reduce their usage to reduce capital expenditures. Correspondingly, in the case of Google Cloud, although there are many contractual balances, the confirmation cycle has been extended, which will still lower the growth rate of cloud revenue.

4. Other Google services mainly include Google Play, YouTube subscriptions, and intelligent hardware revenue. In the third quarter, revenue totaled 6.9 billion USD, a YoY increase of 2.1%. Growth rates in the first two quarters had already fallen rapidly, mainly due to the weakness of Google Play. On one hand, this was because of the decline in global gaming revenue. On the other hand, the revenue share was adjusted at the beginning of the year, from a cut of 30% to 15%, with some software developers enjoying an even lower discount of 10%.

In addition, the sales of the Pixel 6A, launched in July, exceeded expectations, especially in Japan where it became the best-selling Android phone.

5. Innovation Business

This includes multiple venture investment projects, the opening and closing of which depends on Google's judgment of their prospects. Therefore, the overall revenue has been fluctuating significantly, but since its proportion in the overall revenue is very low, its drastic changes have little impact on Google's short- to medium-term performance assessment.

In the third quarter, revenue from innovation business increased by 15% YoY to 200 million yuan. However, recently, some media have reported that Google is closing multiple innovative projects due to macro-environmental and project outlook considerations, and a scale-down is expected to be seen soon.

III. Gross profit margin declined MoM due to the increase in content costs

In the third quarter, Google's gross profit margin weakened to 54.9%, significantly lower than the fluctuation range of 56%-58% in the past two years. Under pressure on revenue, operating costs continued to grow by 13%, without an obvious decline on a MoM basis, thus weakening the performance of gross profit margin.

From the cost breakdown, Dolphin analysts guess that it is probably related to the increase in content costs and bandwidth costs after YouTube traffic growth, as well as other costs such as bandwidth.

Google's costs mainly include:

1. Traffic Costs, which refers to the split and traffic purchase costs paid to operators, mobile phone attempts, infrastructure equipment providers, software developers, and Google Network affiliate partners;

2. Other Costs, including content costs, server bandwidth costs, hardware sales costs, etc.

In the third quarter, overall traffic costs increased by less than 3% YoY and remained stable as a proportion to advertising revenue, implying that Google's traffic procurement and monetization efficiency has not changed significantly in search and affiliate advertising businesses. However, other costs increased by more than 19% YoY. Considering that the proportion of YouTube viewing time has continued to increase and Shorts has a monthly active user base of 1.5 billion and daily video views of 30 billion, the high growth in other costs is mainly caused by the stable growth in content procurement and split, and bandwidth costs.

However, these stable investments, while ensuring the supply of users' video browsing, have been suppressed by the pressure from advertising demanders.

Last month, the company announced that YouTube Shorts will start sharing advertising revenue next year, with a split ratio of up to 50%. While expanding revenue, the gross profit margin may also be lowered.

Fourth, the team continued to expand and erode more profits, are they going to face optimization?

In terms of operating expenses that are closely related to employee salaries, the third quarter also continued to maintain a contrarian high growth, with R&D expenses, sales expenses, and management expenses increasing by 33.5%, 25.6%, and 10.5% respectively. As of the end of September, the number of Google employees was 186,779, a year-on-year increase of 25%. The expansion of the team and the wage rise under inflation are the main reasons for the high growth of expenses. With the merger of Mandiant in the fourth quarter, it may lead to the expansion of more than 2,000 personnel.

Such expense growth further weakened the company's profits. The operating profit margin in the third quarter dropped by nearly 4 percentage points, a year-on-year decrease of 18%. In terms of business, Google Services (advertising, YouTube subscriptions, app stores, etc.) fell by 17.5% year-on-year, while Google Cloud's losses improved by 8.5%, which may be related to the company shutting down some low-revenue cloud services.

In the shareholder letter for the third quarter, CFO Ruth Porat mentioned that they are committed to resource adjustment. Does this mean that personnel optimization will be conducted in the future? After all, it is visible to the naked eye that expanding expenditures and boosting revenue is more difficult under economic downturn expectations, especially in the current period when the financial report is further strengthening the expectation of economic recession. Shrinking timely to improve profits is the action that investors would like to see currently.

Google's performance briefings have always had limited information. It is recommended that you pay attention to the content of the conference call, especially the management's outlook on current competition, next year's strategy, and relatively specific revenue and expenditure guidance that may be given.

We will also release the summary of the conference call in the investment research group and the Longbridge app as soon as possible. If you are interested, you can add the assistant WeChat【dolphinR123】to obtain it.

Dolphin Research Collection on "Google":

Financial Report Season

July 27, 2022 Conference Call "Google: Investing in Areas with Better Long-Term Prospects under High Economic Uncertainty in the Second Half of the Year (Summary of Conference Call)"

July 27, 2022 Financial Report Review "Google: Tough Report Card in the Expectation of a Financial Storm"

April 27, 2022 Conference Call "Management Avoided Talking About TikTok, But the Competition Is Still Intensifying Behind the Importance of Shorts (Summary of Google Conference Call)" On April 27, 2022, Comment on the Quarterly Financial Report "Google: Struggling in the Headwinds"

On February 2, 2022, Conference Call Summary "Increasing Investment, Accelerating Recruitment, Google Actively Seeking Expansion"

On February 2, 2022, Comment on the Quarterly Financial Report "Google's Performance Shines, Rare Stock Split, and Google is Soaring Again"

In-depth

On July 1, 2022, "TikTok Will Teach 'Elder Brothers' How to Work, Google and Meta are Going to Change"

On February 17, 2022, "Internet Advertising Overview-Google: Watching the Wind and Clouds Rise"

On February 22, 2021, "Dolphin Research | Analyzing Google: Has the Recovery Trend for Advertising Leading Dragon Ended?"

On November 23, 2021, "Google: Performance and Stock Price Soaring, Strong Repair is the Theme of This Year"

Risk Disclosure and Statement for This Article: Dolphin Research Disclaimer and General Disclosure