Alphabet Earnings: Search and Cloud Growth Remain Impressive

Key Morningstar Metrics for Alphabet

• Fair Value Estimate: $182.00
• Morningstar Rating: 3 stars
• Economic Moat: Wide
• Morningstar Uncertainty Rating: High

What We Thought of Alphabet’s Q2 Earnings

Solid ad revenue growth during the second quarter contradicts the notion that Alphabet GOOG/GOOGL is losing its footing in the search business. Also, growth in the Google Cloud business accelerated again, reaching the fastest pace in 18 months as artificial intelligence tools augment broader cloud adoption. After adjusting our model, we have modestly increased our fair value estimate to $182 per share from $179.

Total revenue increased 14% year over year, roughly on par with the prior quarter. Google search revenue increased 14% to $48.5 billion, with retailers again the largest source of growth. Retail demand, especially among Asian firms, began to pick up during the second quarter of last year and has yet to show signs of slowing. Alphabet also highlighted the early success of AI overviews within search results. Despite early snafus, management indicated that search usage and satisfaction have improved with the inclusion of overviews and that ads have been well received above and below overview boxes. In short, we’ve yet to see strong evidence that new forms of accessing information, like ChatGPT, are blunting search volumes or that other query-based advertising offerings, such as on Amazon, are increasingly eating into traditional search demand.

YouTube advertising growth slowed sharply to 13% from 21% last quarter. Management pointed to a tough comparison versus the initial jump in retailer spending last year, but the search business faced a similar dynamic without the same deceleration this quarter.

Cost controls, excluding the investment in computing infrastructure, continue to boost the operating margin, which expanded to 32% from 29% last year. Total SG&A expense declined 3% year over year, while both the cost of sales and R&D declined as a percentage of revenue. Free cash flow declined sharply to $13 billion from $22 billion last year, primarily due to the timing of cash tax payments. Capital spending, primarily investment in computing infrastructure, increased to $13 billion from $7 billion last year.

Cloud revenue increased 29% versus a year ago and 8% sequentially, surpassing $10 billion for the first time. Cloud profitability also continues to improve, with the segment operating margin more than doubling to 11% from 5% last year.

Operating margin expansion will likely slow across Alphabet’s businesses during the second half of the year as depreciation expenses ramp up following the surge in infrastructure investment. However, the firm still expects efficiency gains across the business to allow the operating margin to expand in 2024 versus the prior year.