Google: Numbers Look Ugly, Playing Catch Up Is Not A Viable Strategy

Summary:

• GOOG’s new accounting methods have accelerated Google Cloud’s profitability and boosted the company’s EPS growth in FQ1’23.
• However, it remains to be seen if the cadence may be sustained ahead, since SBC expenses are now backloaded to the last three quarters.
• Combined with the increased capex in FY2023, we may see GOOG’s FCF generation impacted, likely inline with FY2022 levels.
• It appears that the next-decade AI battle may be expensive for GOOG, especially worsened by the notable deceleration in advertising spend at a time of peak recessionary fears.

We previously covered Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) here, mostly focusing on the market’s pessimistic reaction to the Apprentice Bard mishap. While the company’s AI event might appear hasty and reactive to ChatGPT then, OpenAI’s offering posed no real threat to the advertising giant’s core business model in our view. The company is more than a search engine, in our view.

The GOOG Investment Thesis Appears Shaky For Now

This article will focus on GOOG’s excellent double beat in its recent FQ1’23 earnings call, exceeding our expectations. It records revenues of $69.79B (-8.2% QoQ/ +2.6% YoY) and GAAP EPS of $1.17 (+11.4% QoQ/ -4.8% YoY), though with the latter likely attributed to the company’s delayed Stock-Based Compensation [SBC] expenses to later quarters.

Therefore, investors must also be aware that FQ2’23 numbers may not be as attractive, since “the shift in timing itself will not affect the amount of stock-based compensation expense over the full fiscal year 2023, (only) resulting in relatively less expense recognized in the first quarter compared to the remaining quarters of the year.”

Nonetheless, GOOG’s search engine moat appears safe, attributed to the Google Search/ other revenues of $40.35B in FQ1’23 (-5.3% QoQ/ +1.8% YoY). These numbers are not too bad indeed, compared to the FQ1’22 cadence of -8.5% QoQ/ 24.2% YoY and the FQ1’20 cadence of -9.8% QoQ /+8.6% YoY, due to the noticeably impacted advertising market.

The same cadence has been reported by another advertising giant, Meta Platforms (NASDAQ:META), with revenues of $28.64B (-10.9% QoQ/ +2.6% YoY) and EPS of $2.20 (+25% QoQ/ -19.1% YoY). The deceleration in the advertising market is natural, in our view, due to the tougher YoY comparison, significantly worsened by the increased likelihood of a recession by H2’23.

For now, the S&P Global Ratings expects the US advertising market to grow by only 2.8% in 2023, compared to the 9.8% reported in 2022 and 25.8% in 2021. Particularly, the deceleration in advertising spend is most notable in the financial services, technology, and Media/ Entertainment segments. However, with the two advertising giants’ leading market share of 48.4% in the industry in 2022, we believe the headwinds may not be that severe in the near term.

Meanwhile, anyone concerned about ChatGPT and Bing potentially eating GOOG’s lunch may also rest their worries for now. For one, Microsoft Corporation (NASDAQ:MSFT) has recorded tremendous growth in Bing users to 100M of DAUs by early March 2023, expanding six-fold within a month.

However, this number has yet to be translated to advertising dollars, since it only records search and news advertising revenues of $3.05B in the latest quarter (-5.2% QoQ/ +3.7% YoY). Therefore, despite all of the ChatGPT and AI hype, it seems that GOOG’s moat remains safe, depending on Bard/ Bing’s rate of growth and adoption ahead.

GOOG continues to grow its global desktop search engine market share to 85.53% (+0.56 points YoY) by March 2023 as well, compared to Bing at 8.23% (+0.18 points YoY).

In addition, Google Cloud has finally reported its first profitable quarter, with excellent revenues of $7.45B (+1.9% QoQ/ +28% YoY) and operating margins of 2.5% in FQ1’23 (+9 points QoQ/ +14.6 YoY). This is on top of its expanding remaining performance obligations worth $61.7B (-4% QoQ/ +22.1% YoY).

Then again, investors must be aware of GOOG’s new accounting methodology, which comes from the extended “useful life of its servers from four to six years and network equipment from five to six years.” This triggers a reduced depreciation of $998M and an increased net income of $770M.

Therefore, it is uncertain if this profit cadence may be sustained over the next few quarters, especially given Ruth Porat, the CFO of GOOG’s contradictory commentary in the recent earnings call:

We are intensely focused on all elements of the cost space and the long-term path to attractive profitability. At the same time… we will continue to invest to support long-term growth, in particular, given the opportunities we see delivering AI capabilities to our customers. So, as I have said in the past, you shouldn’t extrapolate from quarter-to-quarter. (Seeking Alpha)

Meanwhile, the rate of growth in the Google Cloud’s remaining performance obligations is impressive, compared to MSFT’s unearned revenues for Intelligent Cloud/ Azure at $15.55B (-1.7% QoQ/ +7% YoY), though lagging behind AMZN’s AWS performance obligations of $122B in the latest quarter (+10.5% QoQ/ +37.2% YoY).

As a result of GOOG’s long-term dominance in AI and its increased focus from the combined Google DeepMind, we believe the stock may eventually break out of this slump, especially given the uplifted market sentiments once the Fed pivots by speculatively 2024.

Nonetheless, with the company likely to engage MSFT in the next-decade AI battle, there may be increased expenses ahead. In FQ1’23 alone, it reports R&D expenses of $11.46B (+11.6% QoQ/ +25.7% YoY), while guiding a “modestly higher” FY2023 capex than FY2022 levels of $31.48B, with investments to “step up from FQ2’23 onwards.”

Based on these comments, we may see GOOG generate inline Free Cash Flow [FCF] at approximately $60B in FY2023, drastically reduced from the previous consensus estimate of $70.4B. Then again, with cash/ short-term investments of $115.1B (+1.1% QoQ/-14% YoY), the company remains well capitalized to pursue its AI ambitions no matter the short-term uncertain macroeconomic outlook.

So, Is GOOG Stock A Buy, Sell, or Hold?

GOOG 1Y Stock Price

The GOOG stock continues to trade sideways at the current resistance level, suggesting Mr. Market’s lack of willingness in rewarding its exemplary performance. The sluggish stock movement puzzles us as well, especially given the announcement of its $70B share repurchase program in FQ1’23, similar to the FQ1’22 numbers.

In FY2022 alone, it retired a total of 0.53B shares at an average price of $111.88, totaling $59.3B. With the company repurchasing $15.1B of shares in FQ1’23 at an average price of $96.17 and a total of $98.1B ($28.1B remaining and $70B new) left in its program, the company may potentially retire more shares at these depressed levels, returning further value to its shareholders.

Assuming another $45B exercised from FQ2’23 onwards at an average price of $110, we may see GOOG’s share count further decline to 12.42B, down by -5.5% YoY while being accretive to its EPS by +5.7% at the same time.

Then again, perhaps Mr. Market expects the company to better allocate its resources towards Research & Development, given the optics of GOOG playing catch up to MSFT’s first-mover advantage in the AI race. This is especially worsened by the likely impacted earnings and FCF generation from FQ2’23 onwards.

Notably, the sum is also what the latter plans to pay for Activision (NASDAQ:ATVI), a deal that may drive the software giant’s growth and ambition in the gaming market by leaps and bounds. Otherwise, sevenfold of the $10B pledged to OpenAI.

Either way, given GOOG’s historical movement over the past few months, we prefer to rate the stock as a Hold here. While we remain convinced about the moat of its Google Search engine, it appears that the management continues to lag behind MSFT’s growing lead, with profitability increasingly on the line.

Combined with the minimal upside potential to our moderate price target of $120.34, based on the market analysts’ projected FY2024 EPS of $6.20 and its 1Y P/E mean of 19.41, we do not recommend anyone to add GOOG here. It may be more prudent to wait for another retracement to the March 2023 top of $95 for an improved margin of safety.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOG, MSFT, META either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The analysis is provided exclusively for informational purposes and should not be considered professional investment advice. Before investing, please conduct personal in-depth research and utmost due diligence, as there are many risks associated with the trade, including capital loss.

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