Alphabet Earnings: Google Search and YouTube Growth Doubts Are Subsiding; Stock Remains Attractive

Alphabet Stock at a Glance

• Fair Value Estimate: $161
• Morningstar Rating: 4 stars
• Morningstar Uncertainty Rating: High
• Morningstar Economic Moat Rating: Wide

Alphabet Earnings Update

We maintain our $161 fair value estimate on wide-moat Alphabet GOOG, GOOGL and continue to view it as attractive. Growth in search and cloud, plus a turnaround in YouTube, drove the firm’s impressive second-quarter revenue growth.

Accelerating growth in Google’s core search business demonstrated that the segment’s network effect moat source is intact, despite threats from Microsoft and OpenAI. Also, as we expected, YouTube ad revenue returned to growth due to a more balanced mix of broad-based and direct response ad demand, improvement in YouTube Shorts monetization, and increasing demand for ads on connected TVs. We were surprised by another revenue decline in Google’s advertising technology offerings but expect that segment to improve as economic uncertainty lessens and ad spending across the internet picks up.

Google’s Cloud Momentum Continues

Google’s cloud momentum continued with impressive top-line growth and margin expansion. While management remained cautious about future cloud growth, we look for revenue acceleration, driven mainly by increasing demand for artificial intelligence tools and features.

Total second-quarter revenue came in at $74.6 billion, up 7% from last year. Advertising revenue returned to growth (up more than 3%) after two consecutive quarters of a decline, with improvements in both search (up 5.6%), which was driven by strength in retail, and YouTube (up 4.4%), partially offset by the ongoing weakness in advertising technology revenue (down 5%). Cloud revenue increased 28%, and other services, which includes hardware and Google Play, was up 10%.

Operating income of $21.8 billion (29% margin) was higher than last year’s $19.5 billion (28% margin) helped by a slight decline in traffic acquisition cost as a percentage of advertising revenue and the longer useful lives assumed for servers and other hardware, which resulted in lower depreciation expense. Lower sales, marketing, general, and administrative expenses as a percentage of revenue also contributed to the higher operating margin.

Ad Spending Improving

We expect ad spending will continue to pick up given the resilient economic backdrop. While ad-holding firms such as Omnicom and IPG disappointed the market recently, we think investors have misperceived their second-quarter results as an indication of lower ad spending. In fact, the media buying segments of those firms posted strong revenue, which indicate that advertising spending by large brands may be picking up. This was supported further by the strong growth in broad-based ad demand on YouTube in the quarter. On the other hand, we continue to think that the firm could be forced to pay higher traffic acquisition fees not only to Apple but also possibly to Samsung.

Regarding search, Google’s second-quarter numbers show no evidence of lost market share to Microsoft Bing. While it is still too early and search revenue deceleration and some market share loss may happen, we think Google will maintain its search dominance. Also, on the earnings call, Google management mentioned that it is receiving positive feedback regarding its generative AI-capable Bard search chatbot and search generative experience, or SGE, the firm’s latest search platform to combine generative AI and traditional listing search.