Alphabet Delivers on AI and Cloud—But Is It Enough to Fuel Growth

Alphabet Delivers on AI and Cloud-But Is It Enough to Fuel Growth?">

Stocks powered higher yesterday on optimism about what tech earnings MAY have in store. Job openings declined, according to the latest JOLTS report, and investors are still unsure if a softening labor market is good for stocks or bad for stocks.

Searching for gains. After last night's close, AI fanboys had their first real look at the state of the AI union with Alphabet's Q3 earnings release. I could just simply say that the company beat earnings and revenue estimates and punch out for the day, but you know that simply beating on those is no longer enough to quench investors' thirst for growth, growth, and more growth. Everyday investors are getting smarter, and they want to know how the company beat estimates, whether their big investments are paying off (future growth), and by how much the company beat estimates.

In the case of Google, which is now the company's nickname - wait, why did they ever change its name to Alphabet again - in the case of Google, the undisputed king of search and digital advertising, the bar is really high. The total addressable market for digital advertising and traditional search is well known, and while there is competition, Google is the clear leader in the space. Therefore, so grows the market, so grows Google's ad revenue. The challenge is that the market is maturing, meaning its growth is no longer what it once was years ago. To be clear, the company's $65.5 billion quarterly revenues from advertising are nothing to sneeze at, but in order to be considered a "growth" company, it must demonstrate - er, growth, and Google's ad business is extremely stable, but not growing. Therefore, if advertising was the company's only business, it would be technically considered a value company like Coca-Cola. Investors in those companies are hoping that they maintain market share and pay consistent dividends. With that, Coca-Cola has a 2.92% dividend yield, and Alphabetonly sports a 0.23% dividend. In the case of dividends from steady earners, more is good (assuming cash flow is stable as well), so Google would lose out to Coca-Cola in a battle between value companies.

Thankfully, no one thinks of Google as a value company. So, then, what could the company do in order to earn its status as a growth company and justify its 19.1x forward PE, and perhaps, even more importantly, expand its PE multiple to the 21.6x mean of its peer group? Well, the answer should be simple. Google needs to invest in other revenue sources that match the promising future growth of its peers. Of course, we all know that the company has been doing that. The company earns ad revenue through search (most traditional), YouTube, and its Google Network. Its YouTube service has the potential for growth through content and subscription increases, though that market is also more mature. Outside of its ad business, most notably, is Google Cloud. Google Cloud offers traditional cloud services, competing against Amazon, Microsoft, and IBM (there are others). That is considered a growth opportunity with the emergence of generative AI which relies heavily on cloud computing to do its thing. In that growing market with large competitors the company must demonstrate its ability to take market share away from the competition. That requires significant infrastructure investment, aka CAPEX, or Capital Expenditure. Quite simply put, the company needs to buy servers, software, etc. to be able to outsource computing.

At a high level, a server is a server is a server, so it can gain no edge just in a server arms race. No. It is the software infrastructure and tools it offers to potential clients that can differentiate the company and win customers. That is where Google can demonstrate an edge. And that is what investors really want to see.

Beyond cloud computing, there is Google's Gemini AI service. Google was notably a bit late to the game in AI, having been beat by OpenAI and its partner Microsoft, but it has made major efforts to catch up and earn its rightful place in the big 3. I am sure that I don't need to remind you that AI services are considered a HUGE growth opportunity, though it is still not completely clear how companies will monetize the service effectively. That said, it is still early days, and investors are looking for subscriber and API growth (an API is how other service companies access its core service). Finally, Google has notably invested in other businesses like maps (Waze) and self-driving cars (Waymo).

So, now that we established that Google cannot impress on its core ad search business alone, how did it fare in those other growth areas in the last quarter? In its subscription and platform businesses, the company beat revenue estimates by 8.8%. Google Cloud beat analysts' revenue projections by 5.2%, and those "other bets" beat by 2.67%. Remember that there are costs to providing these services, and the company's ability to profit on those businesses is critical. Investors, as one would suspect, are interested to know how profitable its cloud business is, and its $1.947 billion operating income on cloud services for the quarter exceeded analysts' estimates by 76% ! The company's overall operating margin of 32.3% topped analyst estimates as well. With its Gemini platform, revenue generation through subscriptions grew by 14x in the past six months, which is positive. Finally, YouTube subscriptions, the potential growthiest area in its core ad business experienced a healthy +20% subscription growth.

Overall, the company's revenue grew by 16.4% and its net income increased by 33.6%. With the S&P500's expected growth in those areas of 4.4% and 9.6% respectively, Alphabet has demonstrated its ability to be considered a growth company, after all. Perhaps that is why the company is trading up in the premarket. Google's performance sets the benchmark for the remaining Mag-7 stocks, 4 of which will announce their results today and tomorrow. We will have to wait for the unofficial leader of the AI party, NVIDIA, until the end of November, but there is plenty to chew on until then, and dare I say it, the Mag-7 are not the only stocks capitalizing on AI these days, so don't fall asleep at the switch.

YESTERDAY'S MARKETS

NEXT UP

• ADP Employment Change (October) beat estimates, printing 233k, an increase of last month's upward revised 159k jobs. That is positive for the labor market, maybe not positive for those who are hoping for more rate cuts sooner.
• Annualized Quarterly GDP (third quarter) came in at 2.8%, lighter than estimates by 0.1%, and lower than the prior quarter's 3.0% growth. This is slightly negative for the economy but positive for those hoping for a more dovish Fed.
• Pending Home Sales (September) are expected to have grown by 1.9% after inching higher by 0.6% in the prior month.
• This morning's earnings: Humana, Biogen, ADP, Shake Shack, and AbbVie all beat on EPS and Revenues, while notable misses were logged by GE Healthcare, Otis Worldwide, Zimmer Biomet, Caterpillar, Eli Lilly, Martin Marietta Materials, Kraft Heinz, Fortive, Vulcan Materials, and Wingstop. After the closing bell earnings: Meta, DoorDash, MetLife, Carvana, Robinhood, Twilio, Coinbase, Microsoft, Etsy, Starbucks, Monolithic Power, Amgen, and eBay.

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