Hi YXI friends,

Today, we are going to review the latest set of Q2 earnings for Alphabet (GOOGL). Alphabet is listed on NASDAQ through both GOOGL and GOOG. The difference is that GOOGL shares enjoy voting rights.

We analyse the stock through a wide array of lenses to get an in-depth yet rounded view of the company fundamentals as well as the technical price action.

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DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Google Search is still the big brother in the room

Alphabet’s revenue breaks down into two main groups: Services and Cloud.

Within Services, Alphabet enjoys advertising revenue from Google Search, Youtube Ads, and Google Network. Alphabet also receives revenue from customer subscriptions, Google Plays platform fees, and hardware like Pixel.

For Google Cloud, Alphabet generates revenue through consumption-based or subscription fees for its Cloud platform, including cybersecurity, databases, and AI offerings. Google Workspace, including Gmail, Docs, Calendar etc are also under the Cloud umbrella.

Among all revenue streams, Google Search is the dominant revenue stream, creating 57% of all revenue. The other revenue streams are fairly similar in size, taking between 9 and 12% of revenue share each.

2. Google Cloud sustains impressive growth

In Q2, Google Cloud rose by 29% YoY. This was a similar pace to Q1. Cloud revenue crossed $10 billion for the first time, with over $1 billion in operating profit. The main revenue driver has been Google’s AI infrastructure and solutions used by developers. If a standalone business, Google Cloud would be regarded as a growth stock.

Some back-of-envelop maths: if annualised at $40 billion in revenue with near 30% growth, and we stick on a growth-adjusted-multiple of 18x like Cloudflare, Google Cloud could be worth $720 billion alone (GOOGL’s market cap is $2.1 trillion).

Google Search, Youtube Ads, and Google Subscriptions, Platforms, and Devices grew at a similar speed at 13-14% YoY. This is a slowdown compared with Q1, when Youtube Ads grew by 21% and Subscriptions grew by 18%. Google Network showed negative growth again this quarter, declining by 5%.

Google is looking for new ways to improve search results by providing AI Overviews and visual search via Lens. For YouTube, their focus is on monetising YouTube Shorts in the US, which directly compete with TikTok and Instagram Reels.

3. Overall performance mostly good…

Alphabet’s revenue growth has finally got out of the mud in the past year, with a fourth double-digit YoY-growth quarter in a row. It puts the Q2 TTM revenue at 13.4% growth.

For Q3, we also expect a similar growth rate.

The gross profit, operating profit, and EBITDA margins all look solid on a GAAP basis. I have included the stock-based compensations in expenses when calculating these margins.

4. Will CapEX become a bottomless pit?

Unfortunately, the nice margins stop when we cross from EBITDA to Free Cash Flows.

The reported CapEx in Q2 was $13 billion, driven primarily by investment in technical infrastructure such as servers and data centres. Some of it is also going into investments in office facilities.

Alphabet is on a rising spending spree in this area to support its AI infrastructure and solutions. As a percentage of the revenue, CapEx has risen from sub-10% just a year ago to now over 15%.

Changes in the Net Working Capital have also deteriorated in the past year, meaning the business is sending money faster than collecting it.

Management guides > $12 billion of quarterly CapEx for the rest of the year to keep Alphabet competitive in its AI and Cloud offerings. This means free cash flows are going to take a back seat.

5. Valuation seems fair versus growth

We tackle GOOGL’s valuation through 3 sets of lenses: the absolute value, historical valuation versus growth, and comparable valuation versus peers (covered in Section 6).

On an absolute basis, 6.3x EV/ Revenue for 13% growth or 18x EV/ EBITDA for 30% growth do not look too stretched. The LTM and NTM PE ratios are both in the low 20s.

The blemish is the negative Free Cash Flow Growth, i.e. the big cash burn that the company is going through to compete in AI. Great if it can unlock accelerating growth, but not so great if it can only just keep up with the threats from Microsoft and Meta.

GOOGL’s historical valuation also suggests that the current valuation seems in line. Believe it or not, GOOGL used to grow at 40% p.a. not very long ago.

While the revenue multiple seems high compared with historical levels, the earnings multiples do closely match the growth trajectory.

6. But cheaper Magnificent 7 peers to buy?

How does Alphabet compare with its Magnificent 7 peers?

In terms of forward revenue growth, GOOGL doesn’t look too bad compared with MSFT, AAPL, and TSLA in terms of revenue multiple vs growth. NVDA, AMZN, and META offer slightly better value.

So, middle of the ballpark.

It’s the same story when it come to the EBITDA multiple vs their 2-year forward growth. GOOGL doesn’t look rich priced, but NVDA, and META look better value.

Finally, we look at the growth-adjusted-multiples across the board. This is like the famous PEG ratio, but applied to revenue, EBITDA, and PE using 2-year forward growth rates (to smooth out spikes). PEG of <1 is usually regarded as cheap.

GOOGL is in line with AMZN and META. NVDA is very good. AAPL and TSLA are off the chart expensive.

7. Discounted cash flow model flashes Neutral

These are my base-case assumptions:

• Revenue growth slows from 13% to 5% between 2025 and 2033.

• CapEx goes back down to 10% over time.

• An EBITDA margin of 40% and stock-based compensation at 7% of revenue

• Perpetual growth rate is 1.8% as per the Fed’s long-term GDP growth forecast.

• 10-year bond yield at 4.3%

• WACC at 10% given the current equity/ debt ratio and GOOGL’s cost of debt on the secondary market.

The DCF model shows a fair-value price of $120 (30% downside) if we include stock-based compensation as real cashflow items, and $157 (9%) if not.

We can also create a bullish case of revenue sustaining between 10%-15% in the next decade, with the EBITDA margin up to 45%, and CapEX down to 7% over time. Then dial up the perpetual growth rate to 3%. The model suggests a fair-value price of $187 (8% upside) if we include stock-based compensation as real cashflow items, and $232 (34%) if not.

Of course, if Alphabets leads in the AI race, there is no reason why it won’t command even higher growth rates and margins.

A quick note: the inclusion of SBC is a topic of contention. Management loves to leave it out in the long-term guidance as the numbers look much better, but many would also argue the cost is real due to the dilutive effect on shareholders. In my analysis, I compare both sets of outcomes to gauge how the market is pricing the stock.

8. Price actions face headwinds

Finally, we get on the most exciting part of our analysis - technical chart analysis!

GOOGL Daily Chart (Click here to expand)

GOOGL’s price has more than doubled since the beginning of wave 1 in January 2023. The latest wave 5 has been a straight-up exercise which I very much underestimated in my previous updates. That has also been the story of the entire market this year.

I do see wave v of 5, therefore wave 5, now likely to have completed, having made past the 3.618 extension of wave 1 from the wave 2 low.

We need a bit more time to see where wave A lands, but my current estimate is a 50% retrace to around $137. But we need to see an initial 1-2 setup from the top to be more precise. Interestingly, if we complete wave C at the 0.618 retrace, we would actually get into the fair-value zone from the DCF model base case assumptions.

9. Where are we in the larger cycle?

There is also a larger degree question, which is where are we now in the stock’s entire cycle?

Let me bring up this scary (or super-bullish?) chart.

GOOGL Monthly Chart (Click here to enlarge)

It would seem that wave III of the stock’s cycle from 2004 completed at the 3.0 extension of wave I from the wave II low.

Given where wave III is, wave V does not feel quite complete yet. But technically, it can count as complete. We will keep this larger picture in mind as we monitor the step-by-step progress of GOOGL.

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— Yimin