Sean Gallup
No company is immune to looming macroeconomic headwinds, yet Alphabet Inc.’s (NASDAQ:GOOG, NASDAQ:GOOGL) (“Google”) Q3 2022 results have proven that it continues to be more resilient than most – especially its ad-focused peers that continue to reel from the double-whammy of macro-driven ad spending weakness and Apple’s (AAPL) signal loss. Despite the weight of FX headwinds which were largely expected given the rapid surge in the dollar in recent months and observed in the large gap between Google’s 6% y/y revenue growth and the 11% constant currency equivalent, the company continued to benefit from “growth in Search and momentum in Cloud.”
Google Search and YouTube advertising demand was a key focus area for many investors heading into its latest earnings release, as talks about softening ad spending have gained momentum in recent months. Markets have been bracing for a slowdown in consumer spending and an impending recession. Investors’ angst only worsened after advertising peer Snap Inc. (SNAP) reported the “worst revenue growth rate in its history,” elevating concerns over rising competition and broader macro headwinds. However, Google’s delivery of advertising sales growth in Q3 2022 (inclusive of FX headwind) suggests it continues to benefit as a market leader, as advertisers remain cautions on the allocation of ad dollars, favoring the best “value for money” ad distribution channels amid a looming economic downturn.
Google Cloud is another key spotlight for the company, as the segment maintains momentum by benefiting from the increasing adoption of a multi-cloud strategy across the commercial sector. The segment’s continued growth also contributes positively to its profitability trajectory – something that investors are hoping would come soon to match the lucrative margins achieved by rivals AWS (AMZN) and Azure (MSFT).
Solid fundamentals backed by a sustained moat, paired with its increasing share in the burgeoning cloud market continues to be the key bullish narratives driving the Google stock’s forward uptrend prospects. While Google has made a few brief appearances in the sub-$100 level over recent weeks, we remain optimistic that the stock has found bottom at current levels of about 20x forward earnings compared with the large-cap median of around 28x.
Google Shows How Valuable Its Moat Is
Google’s moat in digital ads has long been dubbed its key bullish thesis. Yet, nobody has really seen how strong and resilient it has become until the rapid deterioration of global macroeconomic conditions observed in recent months. The company’s 3Q22 ad revenue growth (+6% y/y; -1% q/q, inclusive of FX headwinds) continues to demonstrate not only the competitive advantage of its market dominance, but also the prudent management of its ad business strategy with diversified distribution outlets to mitigate concentration risk (cue social media turmoil with data signal loss).
Major challenges in digital advertising today include diminishing ad dollars ahead of a looming recession, industry-specific headwinds regarding restricted user data access, and an overall increase in competition. But Google’s moat with Search and YouTube continues mitigate its exposure to such risks.
Digital formats currently account for close to two-thirds of ad placements, displacing traditional distribution channels (e.g., linear TV; radio; paper). The majority of ad dollars were allocated to digital media in 1H22, with search and short-form video being two of the most common platforms, boasting 19% and 14% y/y growth, respectively. And the trends are expected to last in the foreseeable future, with search ads expected to close the current year with at least 17% y/y growth, and short-form video/streaming 22%.
This continues to make strong tailwinds for Google’s advertising business, representing a massive growth opportunity for its moat to capitalize on. This is especially true under the current market climate, where advertisers are looking for distribution formats that can provide good value for money. YouTube currently accounts for 8% of all TV usage in the U.S. alone, beating Netflix’s (NFLX) 7%, which supports favorable reach for ads. Despite rising competition from TikTok on capturing share of total user screen time, Google’s equivalent YouTube Shorts are capitalizing on digital advertising opportunities well by improving monetization and enabling ad revenue sharing with content creators. Meanwhile, Google Search remains the leading online search engine, facilitating close to 10 billion search requests per day.
Merchants currently spend on average 3.8% of its revenues on advertising, which is a material number considering the increasing focus on expanding profit margins to brace for the impending market downturn. Recent research shows that ad spending needs to be within the range of 1% to 9% of revenues paired with a fair “channel mix” in order to achieve optimal engagement and conversion results. With Google Search and YouTube being dominant ad distribution engines today, the company continues to be the best choice for all advertisers and merchants, large and small.
In addition to favorable market trends, Google’s advertising business is also expected to benefit from improved ad spending ahead of the upcoming holiday season. Industry trackers continue to show that m/m ad spending has steadily increased since September, with holiday advertising budgets “ratcheting up” earlier than expected this year in October. This is further corroborated with expectations for the holiday shopping season to start earlier this year, as consumers look to take advantage of sales and discounts to compensate for rising inflationary pressures.
In addition to expectations for improved demand volume in 4Q22, we also think Google will benefit from pricing gains. Specifically, recent 3P data has demonstrated some “bias in ad spend towards [Meta Platforms] (META) compared to Google due to [return on ad spending / cost per action] (“ROA” / “CPA”) improvements via Advantage+” (Advantage+ is a new advertising format offered by Meta Platforms – see more here). While this may seem like competition headwinds for Google, we think its higher cost per mille (“CPM,” or cost per every 1,000 ad impressions) will pay-off over the longer-term. This circles back to Google’s moat in digital ads – its platforms deliver. Although Meta Platforms has been lowering its ad pricing steadily this year to attract better take-rates and compensate Apple’s signal loss headwinds (which is good for the company, in our opinion), we think the fact that market expectations for social media ad spend to fall from 38% y/y growth last year to merely 3.2% y/y growth this year continues to corroborate more robust demand for Google’s advertising formats within the foreseeable future – especially as advertisers remain cautious on ad spending in the near-term.
GCP On Cloud 9
Although Google Cloud Platform (“GCP”) is currently the third largest public cloud service provider, it has always been the underdog given the glaring distance between its market share size compared to AWS and Azure’s. Yet, the increasing adoption of a multi-cloud strategy across corporate settings due to benefits spanning “risk mitigation, reliability/redundancy”, multi-function availability, and most importantly, cost-efficiencies is narrowing that gap for GCP from its leading contenders. And the segment’s robust 3Q22 results (revenue +38% y/y, +9% q/q; operating loss lowered by 19% q/q) solidifies that outlook.
Looking ahead, we see a continuation of this gradual build-up in GCP momentum supported by favorable take-rates observed across both large enterprises and small- and medium-sized businesses. And this will be critical to bringing the segment to ultimate profitability that imitates the ever-expanding margins observed at AWS and Azure through rapid scale, providing another cash-generating moat for the consolidated company.
Currently, close to 90% of corporations that have begun their respective transitions from legacy IT infrastructures to the cloud have indicated that they use “multiple public cloud providers,” with many indicating spending intentions on GCP in the foreseeable future, underscoring potential for greater penetration into opportunities across large and medium-sized enterprises currently dominated by AWS and Azure within the near-term. GCP is also gaining traction among small enterprises, tying with Azure in second place in terms of market share at 30%. Although SMBs are typically considered the more recession-prone cohort, which could potentially subject GCP to greater macro risk exposure within the near-term relative to AWS and Azure, cloud budgets have remained resilient so far:
[Dan] Ives said cybersecurity earnings should also hold up well as spending on cloud transformation projects, data analytics and hybrid cloud integrations are still getting “green lighted” by many companies due to budgets already being set going into next year.
Source: Seeking Alpha
This is also consistent with findings discussed in our previous coverage, where the migration to cloud remains a key deflationary factor:
Google Cloud’s continued growth trajectory is further corroborated by resilient demand despite broad-based macro challenges – building a digital fabric remains a critical mission for the commercial sector in order to ensure “improved productivity in the inflationary environment”, meaning IT spending on migrating workloads to the cloud and other digital transformation projects will remain strong.
Source: “Google’s Post-Earnings Rally Signals The Bottom Is In”
We also view Google’s plans to penetrate underserved markets as a prudent strategy to address the massive market share gap between GCP and market leaders AWS and Azure. The company’s latest decision to introduce its cloud-computing services in South Africa as part of its $1 billion multi-year investment strategy in Africa is expected to further its global market share within the fast-expanding industry. By building out local cloud infrastructure in South Africa, GCP ensures reliability of its services provided, while also addressing local data storage requirements, making it an optimal choice for the region’s commercial segment.
In addition to expanding GCP’s global availability to bolster its competitiveness within the cloud-computing market, Google has also ramped up its AI capabilities and related offerings, addressing a factor that has become increasingly critical within commercial IT environments. These include the recent introduction of Vertex AI Vision, an AI-enabled image recognition tool; Translation Hub, which uses AI to translate entire documents in 135 different languages; and Contact Center AI, an AI-enabled customer service tool. By double-downing on developments in AI/ML, Google effectively bolsters GCP’s ability to address increasing considerations/demand for automation when key decision-makers evaluate IT vendors today. This is also consistent with the fact that more than 40% of corporate employees across the U.S. have pointed to the use of low-code techniques as critical in the increasingly data-driven workplace.
Last but not least, Google’s acquisition of Mandiant this year is expected to further improve GCP growth over the longer-term. Security currently presents itself as the most resilient segment in software amid looming recession risks. Close to 95% of corporate America has suggested that security spend will continue to increase despite near-term macro uncertainties, making it a key investment area due to an increased urgency to protect data from rising cyber threats.
The Google-Mandiant combination has already resulted in synergies, with a new joint cybersecurity initiative – Mandiant Breach Analytics for Chronicle Security Operations – to address said opportunities. Chronicle is a suite of cybersecurity solutions offered as part of GCP. And Mandiant Breach Analytics is the newest cyber threat detection and response tool developed by Mandiant that leverages the “power of the Google Cloud Chronicle Security Operations suite” to enable rapid threat detection and response. Key features of Mandiant Breach Analytics include reducing the time between “cyber intrusion” and “discovery and response” from the current average of about 21 days, and offering “active insight into threats” that can help GCP customers take swift action to “mitigate the impact of targeted attacks, while reducing the cost of current approaches.”
Key Risk Considerations
The irony between Google’s 3Q double-miss and outperforming fundamentals compared to its peer group underscores the impact of growing FX headwinds on the business. With the dollar expected to maintain a rapid rise over coming months as the Fed remains pressed on an aggressive rate hike agenda to tame inflation, FX will remain a near-term overhang on Google’s fundamental performance. More than half of the company’s revenues are currently generated from operations outside of the U.S., underscoring its significant exposure to FX headwinds over coming months. Yet, this is not an idiosyncratic risk to Google – in fact, even if the business shows 100% resiliency against the looming economic downturn, FX impacts will still erode its fundamental outperformance due to the global scale of its business.
Competition is another key risk, though Google is expected to navigate through this business challenge better than peers. On the advertising front, Google continues to benefit from market leading reach, especially in Search. Meanwhile, YouTube remains a key shareholder of daily user screentime. Although YouTube ad revenues showed its first sequential decline in two years during the third quarter, which implies softness in take-rates that were insufficient to overcome FX headwinds, we expect results from the newly implemented monetization efforts on Shorts paired with the platform’s increasing share of user screen time to ramp up and become more evident over coming months. Meanwhile, on the cloud-computing front, we believe GCP’s momentum demonstrated in 3Q22 puts rivals AWS and Azure on notice – if anything, GCP is a rising contender, instead of one that is losing market share within the fast-expanding yet increasingly crowded cloud-computing landscape.
Final Thoughts
Google’s resilience demonstrated through a tough 3Q22 macro environment should assuage investors’ concerns over increasing fragility in ad spending given looming economic weakness. We believe 3Q was a big test for investors’ confidence in the Google stock, and the company’s robust fundamental showing (barring FX headwinds) and favorable forward market trends discussed in the foregoing analysis over the immediate- and longer-term shows it has passed the test.
With Google now trading below “its 10-year average and the Nasdaq 100 overall,” and underlying fundamentals that continue to outperform those of its peers, the latest market selloff has created a compelling entry opportunity for Google stock as a long-term investment.
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