Google Earnings Review: How Much Upside Remains for Google Post-Surge?

The post-market rally of nearly 12% clearly indicates that the market is highly satisfied with Google's earnings results. Given the stark contrast between Meta's sharp decline after its earnings release and Google's substantial surge, where do the divergences lie between these two advertising giants?

Following Meta's earnings release, concerns over a projected slowdown in ad revenue growth in the latter half of the year prompted a nearly 2% drop in Google's stock as well. Despite both companies operating within the advertising industry, market expectations for their performances have differed significantly.

Google's underwhelming overall ad revenue in the previous quarter marked a crucial turning point for its downward trajectory since January. In reality, we believe Google's ad business did not fare poorly during that period; rather, it continued to exhibit a strengthening sequential growth rate. The disappointment stemmed largely from Google having exceeded ad revenue expectations by a considerable margin for two consecutive quarters, coupled with an improving consumer environment in Q4. This led the market to continuously revise upward its outlook for the recovery of the ad business and set higher expectations for Google's ad income.

Since Q4, the market has held cautious expectations for Google's ad growth rate. On one hand, there were concerns that Google's traditional search advertising business might gradually be eroded by the development of AI-powered conversational search. On the other hand, the lingering shadow of the previous quarter's underperformance contributed to a conservative outlook. Thus, the market anticipated a year-on-year decline of 10.32% in Google's ad revenue growth (in contrast, Meta was expected to see accelerated growth).

For both Meta and Google, the broader macroeconomic environment in Q1 2024 was identical: the US economy was exceptionally robust, characterized by optimistic employment conditions and a further dip in the unemployment rate to 3.8% in March. Concurrently, US consumer spending remained resilient, with retail sales rising 0.7% MoM in March, driven primarily by strong growth in e-commerce. Bolstered by this robust economic backdrop, advertising recovery was pronounced, with renewed demand from the retail sector—particularly robust growth among Asian retailers—fuelling ad revenue expansion. Consequently, the 13% YoY growth in ad business revenue this quarter represents a correction of overly conservative expectations.

Chart: Revenue by Business Segment for Google (in millions of USD)

Google's ad revenue constitutes more than 80% of its total revenue and can be broken down into three primary segments: Search Ads, Network Ads, and YouTube Ads, which contribute approximately 60%, 10%, and 10% to the overall ad revenue, respectively. In Q1 2024, all three categories of ad income surpassed market expectations.

Drilling down, YouTube remains the standout performer, registering a year-on-year growth of 20%, significantly outperforming the anticipated 15% increase. According to Nielsen data, time spent watching content on YouTube continues to rise, and compared to its competitors, YouTube's market share within the streaming landscape has expanded. Between January and March, its share grew from 7.9% to 8.1%.

Chart: Breakdown of Google's Advertising Revenue (%)

According to Statcounter data, Google's search engine market share slightly declined to 91.38% by the end of the first quarter (down from 91.62% at the end of the third quarter). However, this attrition was not attributed to Microsoft's Bing, as Bing's market share also dipped from 3.37% to 3.35%.

Chart: Market Share Distribution of Search Engines (%)

We hold the view that the substitution of conversational AI search for traditional search methods will be a gradual process in the long run. In 2024, search business is expected to maintain stable growth, and Google's dominance in the search field will remain unchallenged in the medium term.

Currently, conversational search primarily supports enhancing office efficiency; before it garners a substantial new user base, advertisers' budgets are unlikely to shift rapidly, instead favoring the use of AI tools like Google PMAX to influence ad placements. As disclosed by the company, Google integrated Gemini into P-Max in February, with early results showing promise. Ad campaigns created using P-Max's generation tool have a 63% higher likelihood of achieving good or excellent ad performance, with an average uplift of 6% in conversion rates observed.

Regarding the monetization path for conversational AI search in advertising, Google is still exploring its options, but as the dominant player in search, it enjoys certain advantages in this evolutionary transformation. Rumored collaborations, such as with Apple, exemplify this edge. For instance, Google is experimenting with incorporating AI into the main search results page through partnerships like Circle to Search with Samsung, which allows users to circle content on their screen and ask questions about it for immediate answers. According to management disclosures, search volume via this method is gradually increasing.

Market interest in Google Cloud's growth may surpass that of its core advertising business, as it directly reflects the pull of AI-driven demand on cloud computing. Google Cloud did not disappoint in Q1 24, with its growth accelerating to 28.4%, up significantly from 25.7% in the previous quarter. At the Google Cloud Next conference in early April, the company highlighted numerous successes in utilizing Google Cloud for generative AI applications, suggesting that AI advancements played a significant role in the quarter's accelerated growth.

Comparatively, Microsoft Azure and other cloud services reported revenue growth of 31% during the same period, exceeding market expectations of 28.6%. While this performance is strong relative to Microsoft, it indicates that Google Cloud, with its smaller scale compared to Amazon and Microsoft, is still under pressure to deliver higher growth rates. It is evident that Microsoft Azure continues to benefit strongly from the AI-driven demand, leaving Google Cloud's position in the competitive landscape yet to be firmly established.

Chart: Google Cloud Revenue (in millions of USD)

In response to the surge in AI investment, Google has launched a series of new products in the first quarter to catch up with the AI wave, including the Gemini 1.5 Pro model, the open-source Gemma model, a new generation of TPUs, and the ARM-based CPU product Axion.

Last quarter, the company had already provided guidance that overall capital expenditures for 2024 would exceed those of 2023, with continued increases in both AI-related capital spending and R&D investment. As anticipated, Google's Capex reached $12 billion in Q1, marking a 91% year-over-year increase and surpassing expectations by $2 billion, largely driven by investments in server and data center infrastructure.

Looking ahead, it is likely that capital expenditures in the coming quarters will roughly equal or exceed those of the first quarter.

Chart: Google's Capital Expenditure (in millions of USD)

Turning to the cost and expense side, a noteworthy aspect is the impact of the first-quarter layoffs on the expense structure. Total operating expenses for Q1 stood at $21.4 billion, down 2% year-over-year, mainly reflecting reductions in both selling expenses and general and administrative costs.

Starting from the first quarter, Google has been implementing ongoing cost-saving measures, including layoffs, resulting in a workforce reduction of 1,600 employees compared to the previous quarter. However, this has primarily entailed a restructuring of the cost base, with many of the eliminated positions being replaced by higher-cost AI engineers. In terms of expense changes, the most prominent effect is seen in the optimization of sales personnel, with selling expenses declining by 1.6% year-over-year. General and administrative expenses dropped by 20%, with the largest contributing factor being a reduction in litigation expenses related to legal affairs. Meanwhile, research and development expenses continued to grow, increasing by 3.8% year-over-year.

Chart: Proportion of Various Expenses to Google's Revenue (%)

From Q1, the operating margin has improved to 31.6%. Excluding the impacts of layoffs and office space reductions, the actual margin should have reached 33%. Looking forward to the next few quarters, it is expected that this trend of structural cost cutting will continue. Given the substantial increase in AI investment, Google must find savings elsewhere. The operating margin for 24 is projected to be marginally better than in 23.

This quarter, Google announced its maiden dividend payout, setting a quarterly per-share distribution of 20 cents. From a dividend intensity perspective, the amount is relatively low, with the dividend issuance serving more as a signal to the market of the company's willingness to enhance shareholder returns.

The company also approved a new $70 billion share repurchase program, maintaining a similar scale to previous plans. Considering the previous round of buybacks, Google announced a $70 billion repurchase plan in April 2023 (identical to the 2022 figure), having repurchased $61.5 billion throughout 2023 by Q4. Assuming a $60 billion repurchase in 2024, based on the current $1.96 trillion market cap, the estimated shareholder return rate stands at around 3.1%, lower than the current risk-free rate of approximately 4.65%.

In terms of valuation, Google remains one of the less expensive among the seven major tech stocks. As of April 25th, the company's forward P/E ratio for 2024, based on its $1.96 trillion valuation, is approximately 23x, slightly higher than the post-plunge Meta.

Scenario 1:

In the second half of this year, Google's advertising business will face high comparative base pressures. From a macro perspective, the window for rate cuts has closed, and market sentiment is fragile. Tightening financial conditions could lead to a weakening consumption environment over the coming quarters, putting pressure on ad revenue growth. While Google Cloud is expected to incorporate more AI contributions, increased capital expenditure on AI and growing R&D expenses will exert pressure on the expense side this year. EPS growth is forecasted at 18%/17%/13% for 24-26. Post-market share prices have largely recovered to a relatively reasonable level.

Scenario 2:

Under optimistic conditions, assume the consumption environment remains robust or AI contributes significantly more to Google's advertising search business. Google Cloud is expected to deliver high growth underpinned by AI, with cost-cutting measures such as layoffs offsetting the negative impact of increased capital expenditure and R&D expenses. EPS growth is forecasted at 34%/30%/28% for 24-26. Assigning a 23-25x P/E ratio on 2024 net profits, the target price range is $184-$200.

Scenario 3:

In a pessimistic scenario, if the US economy falls into stagflation, the consumption environment deteriorates sharply, potentially causing severe harm to the advertising business. The progress of AI-driven conversational search eroding traditional ad business may exceed expectations. If Google Cloud's growth lags, with heavy capital expenditure eroding profits, the stock price could experience a significant correction.