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Google parent company, Alphabet (GOOGL.US), is likely to offer higher margins for its cloud business in the first quarter of fiscal year 23. But this data will only be “visual”, since with the help of a With the company’s segmental reclassification, margins could rise by 4% with a negative charge from a 1.5% drop in service segment margins. Revenues are also expected to rise as consensus estimates do not appear to account for the more positive trends in the industry outlook in 2023.

According to Bloomberg Consensus Estimates, the market expects Alphabet (GOOGL.US) to be the following benchmarks:

  • Revenue: est. $57,022 million (-16.2% vs. Q1’22 and -25% vs. Q4’22)
  • Gross Profit: est. $36,958 million (+64.8% vs. Q1’22 and -9.2% vs. Q4’22)
  • EBITDA: est. $26,363 million (+46.2% vs. Q1’22 and +12.7% vs. Q4’22)
  • Net profit: est. $15,612 million (+27.4% vs. Q1’22 and +5.4% vs. Q4’22)
  • Earnings per Share (EPS): est. $1.25 (-4.6% vs. Q1’22 and +9.6% vs. Q4’22)
  • CashFlow: est. $13,492 million (-11.9% vs. Q1’22 and -15.7% vs. Q4’22)

Google Cloud’s growth may turn out to be more profitable and faster than the market initially expected and the numbers will almost certainly show this to be true in first quarter results due at close of session on Wall Street today. But that would be a purely optical move due to reclassifications between segments. I would like to better understand the reasons for the reclassification before validating my views on a faster increase in profitability. In this article, I discuss the impacts of segmental reporting changes to recalibrate metric comparisons ahead of the FY23 first quarter results release, which is expected to be announced on today after market close. We will also see below why we believe that Google can surprise positively in its results, especially in revenue by segment.

Reclassifications of benefits by segments

As we can see in the following graphs, the readjustment of the allocation of resources projects different results based on what was known in previous quarters. This readjustment benefits (blue) the previous margins (orange).

Cloud EBIT margin update effect. Source: Alphabet IR

On average, cloud EBIT margins get an optical boost of about 4%. Google Cloud’s quarterly EBIT margins also improve substantially:

Cloud quarter-on-quarter EBIT margin update effect. font: Alphabet IR

The new ranking shows a much steeper increase (+7.8%) in EBIT margins qoq. Perhaps this new reclassification is more representative of the economic reality. If that’s the case, it’s a very strong sign that Google Cloud’s margin profile looks better than it does. However, it is important to analyze the nature of these reallocations before drawing any conclusions.

Considering that the 4% margin increase in Google Cloud came at the expense of an average margin of 1.5% in the Advertising Services business:

Impact of the update of the services EBIT margin. font: Alphabet IR

The growth rate of revenue

Consensus estimates for FY23 first quarter revenue peg at $68.8 billion. This implies a quarterly drop of 9.5%. Statistically, it is a drop above the company’s historical average, which in the last 10 years has been only 5.1% with a standard deviation of 3.4%. Based on this short time series, one conclusion we can draw that a revenue drop of 9.5% taking place in the first quarter of Alphabet’s year would be slightly less likely than a 1 sigma (normal distribution) event. with 1 standard deviation – the center of the normal bell distribution in the bottom image).

With almost 78% of Alphabet’s revenue coming from ad operations, another way to think about expected revenue growth is to look at the global ad spending outlook for FY23, which, according to eMarketer“is expected to digital ad spend worldwide grows 10.5% year-on-year. Given that most of Google’s revenue comes from advertising where it has a leading market position (89% search market share), it would be reasonable to assume that it would grow similar to the market average.

Therefore, there appears to be reason for Alphabet to exceed consensus revenue expectations.

Microsoft it’s in the game

However, recent times are taking tech companies down a path of extreme growth, where the first come and best product will set the current trend, we are talking about AI. And here Microsoft (MSFT.US) seems to have surprised Google.

The company that created the Windows operating system is encroaching on Google’s territory when it announced last month that its Bing search engine would be powered by AI. A few days ago, Microsoft released the equivalent of a home game: It promised to use artificial intelligence to drastically expand the features of Word, Excel, PowerPoint, Teams and other applications in the Office suite.

In late March we got the first impressions of “Microsoft 365 Copilot” in a pre-recorded online event that followed Google’s attempt to get ahead of the Microsoft news. The search giant showed plans to make AI a “cooperation partner” in its Google Workspace apps, including Gmail, Docs, Slides, Sheets, Meet and Chat.

Many of the promised capabilities are similar, including the ability to use an AI to generate draft emails and documents, analyze and extract information from spreadsheets, and intelligently prioritize emails for response. But for Microsoft, the stakes are much higher on productivity than on search.

Microsoft Office and related cloud services generated more than $67 billion in revenue in the company’s latest fiscal year, up 30% from the prior year and representing more than a third of revenue for the entire company.

The continued growth reflects Microsoft’s successful transition of its Office franchises more than a decade ago from traditional software licenses and on-premises installations to the modern world of cloud and subscription pricing. Now, by adding AI to the mix, the company aims to reinvent Office again.

Although Microsoft is working closely with OpenAI on these technologies, “it didn’t just connect Chat GPT to Microsoft 365,” Jared Spataro, corporate vice president of Modern Work & Business Applications at Microsoft, said in the presentation.
Spataro described the technology as a sophisticated series of interactions between a client’s content and files, Microsoft 365, and a large language model that works with human-readable text.

For the last decade, the search engine market has been an absolute desert. The industry has been dominated by Google, the main subsidiary of tech giant Alphabet with a 90% market share (yes, 90% of the total) in Internet-connected devices worldwide. Given how profitable the search engine market is, this dominance has allowed Alphabet to print money year after year with remarkable consistency. Now its biggest competitor, Microsoft, wants a piece of that pie.

The owner of the Windows operating system and Internet Explorer (now renamed Microsoft Edge) has invested heavily in OpenAI to bring the startup’s disruptive artificial intelligence (AI) chatbot to its Bing search engine. This partnership has investors nervous that Google could dump users if Bing’s search results start to become more useful than Google’s.

Will Google be able to hold its place against the wave of new AI products from Microsoft and OpenAI?

OpenAI’s ChatGPT tools have taken the Internet by storm. With over 100 million users in just 5 months after launch, the human-like AI language model is now considered the fastest growing consumer product in history.

Microsoft, which is an institutional investor in OpenAI, saw this success and decided to deepen its partnership with the startup, investing $10 billion in the company and making its cloud infrastructure service, Azure, the exclusive computing provider for OpenAI. The Azure deal will be lucrative in and of itself given the computational intensity of these AI models, but Microsoft saw an opportunity to go further with this new OpenAI partnership with its Bing search engine.

In early February, Microsoft released a revamped version of Bing that allows users to access the ChatGPT conversational tool directly from the search engine. This was a big opportunity for Google, as Microsoft executives hope the new tool can convince users to switch search engine providers. Bing is estimated to have a global market share of 2.81% compared to 93.37% for Google. It’s too early to tell if this revamped Bing will make a dent in Google’s dominance, but news outlets are reporting that Alphabet is nervous about its search engine competitor for the first time in years.

Google’s strategy to defend its position

While some investors are concerned that Google has been caught off guard by this OpenAI-Microsoft partnership, Google seems ready to fight back. He recently released his answer to ChatGPT, called Bard, which appears to have similar capabilities to those released on Bing. Google was also able to launch AI tools in Google Workspace that are very similar to what Microsoft is now offering to Office 365 customers. Either you had these tools out of the box internally or you have the ability to get them up and running in a few weeks, Google has been able to counter ads for Microsoft products quite easily. And what is perhaps a very important aspect, it did not need to make an investment of $10,000 million for this to happen either.

Perhaps it is too ambitious to say that Google is behind Microsoft in terms of AI. Sure, with this OpenAI partnership, Microsoft has a temporary lead in one aspect of AI (conversational chatbots), but Google has been investing in AI for years. It acquired preeminent AI research institution DeepMind in 2014 and has steadily increased the amount of AI it puts into search results on its search properties, which also include YouTube and Google Maps. For example, when users search Google, they can now get results for exact timestamps on YouTube videos. No one but Google can produce these accurate results, since YouTube is owned by the same parent company.

Technical analysis

Alphabet (GOOGL.US) shares are setting up to break the $107.5/share zone, resistance zone from previous prices and the 61.8% Fibo (blue) level of the last key correction. If results improve expectations or the company offers upbeat guidance on its business, we could see the price break past current levels to recapture the lost $122.5 per share in mid-2022.

GOOGL.US, D1. Source: xStation5

Conclusions: Can Google maintain its position in the market?

We at XTB see quite clearly that Microsoft will have to do more if it wants to gain a significant share of the search engine market from Google. Google has an established user base that it has built through innovative AI tools that enhance its search capabilities and free products that increase switching costs like Google Chrome, Android, and Google Maps. It’s hard to see why it would lose market share if it can continue to counter Microsoft’s new AI products with its own imitators.

Investors in Alphabet should be concerned about the flow of ad dollars into popular apps like TikTok and Instagram (owned by Meta Platforms META.US), which have supplemented search engines for some Gen Z users.

Dario Garcia, EFA
XTB Spain

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