Alphabet Preview: The Advertising moat and DoJ front and center

Alphabet is set to report Q3 earnings on October 29, with expectations for EPS of $1.84, reflecting 19% growth, and revenue of $86.4 billion, an anticipated 13% year-over-year increase. Key areas of interest include advertising revenue, which represents a substantial portion of Alphabet’s total revenue, alongside Google Cloud, expected to grow by 29% to $10.87 billion. The Street is looking for an operating income of $26.44 billion, translating to a year-over-year increase of 24%, as analysts balance optimism around Google Cloud's growth with concerns over softening ad growth and market competition from AI.

Advertising remains a crucial driver, with Google's Performance Max platform enhancing ad revenue by enabling advertisers to manage campaigns across multiple Google-owned channels, improving conversion rates. However, Alphabet faces potential disruption from generative AI, with competitors like OpenAI gaining ground, which could pressure traditional search-driven ad revenue if AI-driven tools capture more consumer interest. Alphabet has embedded its own Gemini AI tools into search, seeking to sustain engagement with AI-driven overviews, especially among younger users, to mitigate the threat from emerging AI technologies.

The ongoing Department of Justice antitrust case adds a significant headwind for Alphabet, potentially impacting the company's exclusive Apple search agreement, valued at around $20 billion annually. Legal proceedings surrounding Alphabet’s practices in digital advertising and app store dominance may also require the company to make operational changes, such as allowing third-party app stores on Google Play. These cases are compounded by an impending "DoubleClick" trial, which could affect Alphabet’s ad dominance if the courts impose restrictions or require structural adjustments.

Another growth area, Google Cloud, is anticipated to generate around 29% growth year-over-year, and Alphabet is actively competing with Amazon's AWS and Microsoft’s Azure by expanding AI-driven cloud offerings and securing notable partnerships. Despite these efforts, Google Cloud represents just 4% of Alphabet’s operating income, underscoring the need for sustained momentum to become a more significant contributor to the company's bottom line. New CFO Anat Ashkenazi is expected to provide insights into Alphabet's cloud growth, cost efficiency, and capital spending, as her fiscal strategies will likely influence the company’s margin trajectory.

Waymo, Alphabet’s autonomous vehicle unit, recently closed a $5.6 billion funding round, highlighting Alphabet's ongoing investment in diversified, high-growth ventures beyond its core advertising and cloud segments. Waymo's lead in autonomous driving technology could enhance Alphabet’s long-term growth prospects if it achieves commercial viability. However, regulatory uncertainties and significant capital requirements make Waymo’s timeline for profitability uncertain, adding a layer of risk to Alphabet’s broader investment thesis.

Alphabet reported solid second-quarter growth with revenue up 13.6% year-over-year to $84.74 billion, slightly above analyst expectations. EPS growth was strong at 31%, marking its sixth consecutive beat, while operating margin improved from 29% to 32%, reflecting operational efficiencies. Despite this, Alphabet’s stock dipped post-earnings as advertising revenue growth decelerated slightly to 11% from Q1’s 13% year-over-year increase, causing some investor concern amid high expectations.

The Google Advertising segment saw total revenue rise to $64.62 billion, led by Google Search at $48.51 billion, growing 13.8% year-over-year, though YouTube ad revenue came in just below expectations. Google highlighted its AI-driven improvements in search and engagement, especially among younger users, and continued progress in monetizing YouTube Shorts and connected TV. However, YouTube's year-over-year subscription growth slowed due to the anniversary of a previous YouTube TV price hike, and AI competition in advertising loomed as a concern for some investors.

Google Cloud was a standout, reaching $10.35 billion in revenue, up nearly 29% and surpassing the $10 billion mark for the first time, with a $1 billion quarterly operating profit. New partnerships and client wins in Cloud, like Oracle and Motorola Mobility, supported strong momentum in this segment, which Alphabet expects to continue into Q3. Looking ahead, Alphabet plans to increase hiring for Cloud and technical roles, which could impact operating margin next quarter. The stock’s recent run-up meant that concerns around decelerating ad growth and AI competition led to a modest pullback in Alphabet’s share price post-earnings.

Alphabet's valuation appears attractive, with the stock trading around 22 times forward earnings estimates for 2024, equating to a P/E-to-growth (PEG) ratio that positions it favorably relative to tech peers. This valuation offers potential upside, especially if Alphabet maintains its double-digit growth in both EPS and revenue through 2024 and 2025. However, the company’s heavy capital spending, especially for AI development, has raised concerns about cash flow stability, with year-over-year capex growth reaching 31% as of Q2, impacting free cash flow levels and potentially influencing future discounted cash flow (DCF) valuations.

In conclusion, while Alphabet remains well-positioned in advertising and cloud computing, Q3 results will hinge on its ability to navigate competitive pressures from AI, regulatory scrutiny, and its capital-intensive growth strategy. Investors will closely watch how Alphabet manages its ad business amid AI advancements and legal risks, alongside updates from CFO Ashkenazi on operational efficiency and potential buybacks, which could impact Alphabet's valuation appeal in an increasingly challenging environment.