Google: Going Nowhere Fast On Fundamentals (NASDAQ:GOOG)

Investment Conclusion

Alphabet’s (NASDAQ:GOOG) disappointing F4Q2022 financial results are consistent with the challenging long-term outlook we outlined in our initiation report on the company published in November.

Longer term, GOOG remains a waning corporation, deriving a majority of its revenues and earnings from technologies it launched decades ago, with no definitive strategy to insulate these segments from the growing competition. Moreover, the firm appears to lack a pipeline that would assume the lead as the current business fades. Citing Artificial Intelligence (AI), as a growth driver appears disingenuous, as given that AI is the focus of most of the technology industry, it would be strange if AI was not being incorporated into Alphabet’s business. In addition, Google Cloud, as a long-term growth driver is hardly a plan, as the business is a distant third in the industry, with market share in single digits. Ultimately, GOOG’s leadership appears oblivious to the struggles building up, that could jeopardize the company’s future. As Alphabet believes it is on track, we do not anticipate any alterations to its unfavorable long-term outlook.

In regard to the short-term, GOOG’s FY2023 revenue growth is likely to be tepid as Google Search is losing market share to competitors, which provide a superior search experience, including more relevant results, greater data privacy, and Environmental, Sustainability, and Governance (ESG) compliance, which customers cite as high priorities. In addition, YouTube audience growth has been declining since 2017. As advertisement revenues are a function of impressions and clicks, decrease in eyeballs associated with Google Search and YouTube will drive down revenues and earnings.

In addition, sales growth related to Google Cloud are likely to moderate, based on dynamics associated with the business and its market. With respect to the market, cloud computing growth is projected to decrease by 17% between 2022 and 2025, due to a pullback in capital expenditure on cloud initiatives, as larger firms digest their investments in cloud infrastructure, made over recent years; and future growth in the segment appears capped, as cloud computing is largely a developed world phenomenon, with most businesses in underdeveloped regions not requiring sufficient computing power to warrant migration to the cloud. In addition, Google Cloud is not popular among enterprises seeking cloud computing services, with a majority of its business derived from competitors of Amazon (AMZN), or firms that favor open source cloud architecture.

In the context of margins, although the recent labor downsizing will counter some of the margin contraction (due to revenue deleveraging), it is noteworthy that the effort is far below the workforce expansion that unfolded during F3Q2022, which indicates that salaries are likely to drive down earnings for the current year.

Considering our thesis that revenues growth is likely to be relatively light and that margins will possibly contract, we expect a shortfall in earnings and free cash flows growth over next the few quarters.

Given the deteriorating conditions associated with Alphabet’s core business categories, we are downgrading the stock to a Hold, and reducing our one year Price Target to $92/share, based on changes made to our 10-year Discounted Cash Flow model. We reduced the normalized 10-year revenue growth rate to 8% from 9%, and lowered the straight-lined 10-year operating cash flow margin to 28% from 30%.

Key Takeaways From The Fourth Quarter

F4Q2022 Results Summary. For the quarter, revenues were ~$76.1 billion (+1% compared to F4Q2021), and earnings per share came in at $1.05 (versus $1.53 during the same quarter last year). On a year-over-year basis, operating margins declined by 500 bps to 24%. Net income for F4Q2022 was ~$13.6 billion, reflecting a decrease of 34%, over the previous year’s same quarter.

During the period, the firm generated operating cash flows of $23.6 billion and free cash flows of $16 billion. At the end of F4Q2022, the company had a cash and cash equivalents balance of ~$21.9 billion and long-term debt of ~$14.7 billion, on its balance sheet.

For FY2022, revenues were ~$283 billion (+10% compared to FY2021), and earnings per share came in at $4.56 (versus $5.61 during the previous year). On a year-over-year basis, operating margins declined by 500 bps to 26%. Net income for the period was ~$60 billion, reflecting a contraction of 21.1%, over the prior year.

Recent Employee Layoffs Appear Disingenuous

GOOG expanded its workforce by ~37,000 during the first nine months of 2022, with a 24% year-over-year growth in F3Q2022, and downsized it employee base by 6% or 12,000, in January. The effort appears to be an attempt to appease institutional investors, clamoring for reductions in spending to adjust for the downturn in earnings, the company has been experiencing, rather than an endeavor designed to optimize operations to improve Alphabet’s long-term financial outcomes.

Management citing challenging macro-economic conditions as the catalyst for the employee downsizing is concerning, as the firm’s continued financial underperformance is driven for the most part by weakening fundamentals, associated with a large fraction of its business. Nevertheless, the labor retrenchment will mitigate some of the margin contraction likely to unfold due to potentially softer revenue growth, expected over upcoming quarters. Cumulatively, the recent reduction in workforce is unlikely to materially impact GOOG’s long-term fortunes.

ChatGPT’s Current Threat Overblown

We tried ChatGPT. The platform responds to search terms with an essay like response. However, the result is casual and lacks essential details. To deeply understand a topic, ChatGPT is insufficient. Therefore, in its present form, we do not view the service as a serious threat to current search engines.

Overall, the essence of the growing prominence of ChatGPT is that AI is likely to be powerful in regards to internet search. However, given that its responses are cursory and lack depth, the platform’s current version will possibly be a fad.

Alphabet Likely To Prevail Against DOJ

The second anti-trust lawsuit brought by the Department of Justice (DOJ), in its attempt to divide GOOG into separate enterprises, is unlikely to achieve its objective, in our judgment. We do not view the effort as credible as a majority of Alphabet’s segments were created with the goal of generating earnings by running advertisements on the platforms, rather than profiting from the content associated with the categories. As content from the ventures were not designed as revenue generators, the initiatives cannot be considered stand-alone enterprises.

In addition, given that the segments under attack from the DOJ, drive a large fraction of Alphabet’s operating earnings, we expect the company to devote substantial efforts and resources to demonstrate their relevance to its advertisement driven business model. Therefore, we view the DOJ challenge as head-line risk, for the most part.

Bottom Line

GOOG is in trouble. It does not like to accept the fact. Hubris apparently is hard at work at Alphabet. Nevertheless, we hope that four quarters of missed analyst estimates have awakened the company up to the fact that it is a business, with a fiduciary duty towards shareholders. It’s not too late. Focus on the current business. Back it up with a solid pipeline. GOOG might appear to be too large to fail. However, weakening fundamentals, aligned with competitive challenges, could deliver a one-two punch, from which it might be impossible to recover. Act now.