I'm Good Enough, I'm Smart Enough, and Doggone It People Like Me: Mag 7 Edition
For the Mighty Goog, "Beat and Fall" is the New "Beat and Raise"
So, Google (GOOGL) beat earnings again. And took a big tumble again. Just like last quarter.
As a reminder of what happened when Alphabet (parent of Google) reported Q3 earnings last October, here’s the snippet I had written to myself after the quarter, so I would remember it all when the Q4 report rolled around.
“Takeaways: Ad growth accelerated in both Search and YouTube, but stock sold off because Cloud growth missed, an overreaction. Investors were ignoring the underlying strength where Google actually makes its money (ads!) because they were disappointed in the growth at the Cloud division of “only 22%”, which missed the arbitrary expectation set by the sellside. In no world other than one ruled by beating estimates is 22% growth objectively bad. Growth in Cloud was still good by any absolute measurement, it just missed the sellside hurdle. They did themselves no favors by spending the whole call blowing smoke about AI, speaking in buzzwords, and not focusing at all on the fact that things sped up in the ad division, the stuff that actually generates earnings and cash flow.”
Or, as I put it more succinctly on Twitter, the day after the report when GOOGL shares dropped 10%:
In October, growth-obsessed tech investors wanted the Cloud division to grow a few points faster. Well, guess what? Cloud did grow faster in Q4! Growth accelerated from 22% back up to 26%. But it still was not good enough.
Again, GOOGL shares dropped the day after earnings - this time by 8% (a falling market that day didn’t help). I wouldn’t be surprised if Google’s management team was flabbergasted at this reaction. I kind of imagined CEO Sundar Pichai standing in front of a mirror doing a daily affirmation – Stuart Smiley style - as he watched his stock tank.
After all, they gave the people what they asked for – faster Cloud growth… and the stuff that had been good in Q3 stayed good in Q4, and in fact even got a little better.
For the second quarter in a row, ad growth accelerated. Search grew 13% in the fourth quarter versus 11% in the third quarter. YouTube Ad revenue growth acceleration was even better. YouTube put up 16% Q4 growth versus 12% in Q3.
Seemed good to me, yet the market didn’t agree.
There was admittedly some hair on the quarter, as there almost always is. The revenue beat didn’t translate into an operating margin beat, so the operating leverage and ongoing cost cutting efforts were a slight disappointment.
There was also talk of an unspecified, but material jump in capital expenditures in 2024, which is almost certainly related to investment in AI. So keeping up in AI is going to be expensive, which should be a surprise to no one, but it is maybe going to be even more expensive than some on the outside – or maybe even on the inside – of Google thought it was going to be.
But the original sin of the Google 4Q23 earnings report was a very slight revenue miss in Search. Expectations were for $48.14 billion in Search revenue, but Google reported a mere $48.02 billion. So there was a $120 million revenue miss in search.
$120 million is a lot of money for almost anyone, but not really for Google. Putting this miss in the context of a business that did $48 billion in the quarter, the big revenue miss at Google Search was 0.2% of analyst forecasts. The stock dropped 10%, meaning that approximately $150 billion in market cap was lost largely over this $120 million revenue disappointment.
The heightened sensitivity to the smallest of misses in Search underlines what the central debate about Google is right now: What will happen to the Search business as AI continues to take over the world? Will Google lose market share in search, and ultimately see its ad revenues decline, as people turn to tools like ChatGPT instead of Google Search for their information needs?
Any Google bear will tell you, with 90% share in Search, there is only one direction that Search market share can go for Google. The perception is that OpenAI’s ChatGPT is ahead of Google’s Bard, and the fear is that an AI service will upend how search queries get done at some point in the not-too-distant future.
The Case for Alphabet/Google
I’m going to address the controversy over search in a minute. But first, let me share the high-level, basic bull case.
Late last year, I was asked by the folks at the Money Show to submit short write-ups, ideally no more than 500 words each, on two of my favorite ideas for 2024. I was advised to make one a blue chip and one something less well known, perhaps a small cap.
Google was my large cap pick – which looked like a good one… until Wednesday this week. Oops. Well, I have 11 months left for this to turn around. And if you are reading this looking for ideas that will outperform over days or weeks – not quarters and years – well, I think you are reading the wrong letter.
Anyway, I will share with you my short write-up on Alphabet that was published in the MoneyShow 2024 Top Picks Report….
“Sometimes it’s better to just keep it simple. As the great Warren Buffett famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Alphabet (GOOGL), parent of Google, YouTube, Android, and a growing cloud computing business, is very much a wonderful company at a fair price.
Much has been made about the outperformance of the Magnificent Seven in 2023—consisting of Alphabet, along with big tech peers Amazon (AMZN), Apple (AAPL), Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA). The group was collectively up 75% in 2023 as of mid-December, driven by the nearly 250% move in Nvidia and 186% move in Meta.
Alphabet was up a relatively tame 54% in comparison, the “laggard” of the group (although that performance is obviously nothing to sneeze about). With this dramatic price appreciation in 2023, these seven stocks now comprise 30% of the market cap of the S&P 500.
Such outperformance and the resultant index domination has spawned a plethora of think pieces suggesting that the move in these stocks is done and that investors will look to rotate elsewhere in 2024. This may prove true for some members of the Magnificent Seven, but I think treating them like a monolith is a mistake.
Consider that the individual members of the Magnificent Seven sport vastly different valuations. While Tesla—arguably the constituent with the smallest competitive moat and most competition in the group—recently sported a P/E ratio over 80 and ecommerce and cloud giant Amazon sported a P/E just under 60, Alphabet traded at just under 24 times 2023 expected earnings.
Sure, that was a premium to the overall S&P 500 index, which traded at 21.5 P/E on this year’s earnings. But it was an extremely modest premium when you consider Alphabet’s superior growth outlook, margins, and financial strength versus the average for the S&P 500.
Alphabet is expected to grow its earnings 50% faster than the S&P 500 next year, and its extremely high operating margin is roughly double that of the S&P 500. Alphabet also has $120 billion of cash and equivalents sitting on its balance sheet—which give it outstanding financial stability and the flexibility to keep buying back stock, which helps propel EPS growth.
In fact, if you adjusted its stock price to back out its cash holdings, Alphabet trades in line with the S&P 500 despite having a much higher profit margin and an incredibly deep competitive moat, particularly in the core search business where Alphabet still sources the majority of its earnings. Paraphrasing Buffett, with Google, you are getting an exceptional company at a decidedly average price. Don’t let the noise about the Magnificent Seven distract you from what should be a really easy investment decision.”
So What About the Future of Search?
The real answer is no one knows. This is very much a “crystal ball question.” There are no firm answers here, only opinions. So here’s mine.
I think this risk around Search is why GOOGL shares are trading at roughly 20 P/E versus Microsoft shares at 35 P/E. It’s an oversimplified analogy... but clearly this long-term uncertainty around search is why this exceptional company is trading at a market multiple right now, with zero premium to the S&P 500. This is why it isn't more expensive. The Search moat feels less deep than it has in a long, long time.
However, I feel like you are being compensated for this risk by the current valuation, and I also think we are in the early, early days of AI and its transformation of consumer behavior. While things are moving quite quickly in the digital advertising world in terms of machine learning being applied to how consumers are targeted and Generative AI streamlining the production process for ads, consumer behavior will likely shift a lot slower.
If you are investing in tech companies or a tech nerd, you have probably spent hours playing with various Gen AI tools. Most people have not.
Googling something is a habit, and habits are often changed slowly. This is one of those instances when understanding consumers may be handy when trying to invest in tech companies.
Here’s an example of consumer behavioral change happening in slow motion: Netflix began its assault on the Pay TV Ecosystem around 2012, and sure, early adopters were cutting their cords by 2015-2016, but mass consumer behavioral change didn't happen until 2021-2022. It took that long for cord cutting to start actually impacting the financials of legacy media companies. Since then, the shift to streaming has of course been swift and catastrophic.
My guess/opinion is that the evolution of search will be slower to come to fruition than tech enthusiasts think, simply because Google search works pretty damn well... and it's free (well you pay with your privacy and to some extent your soul, but no one is hitting your credit card!).
Admittedly, sometimes consumer change can happen fast with new technologies - think how fast physical film died once we all got phones with built-in digital cameras... but there was a big step up in convenience to using your camera phone and a giant cost savings with that move. Remember buying film for $6 and developing it for $14… $20 for 24 pictures!!! I went out last night and my friends and I took about 24 pictures. TBH, I probably have taken 24 pictures of my dogs this week. This would never have been possible or fiscally prudent with film.
But Google Search is not broken, nor is it expensive, so your average Joe may not be feeling the need to fix it... and it can't get cheaper than a direct cost of $0.
My guess/opinion is that search will evolve – but over 5-10 years, not 5-10 quarters. In the interim, YouTube is going to grow like a weed and dominate the connected TV space. And Alphabet will continue to generate tons of cash from Search and You Tube – and maybe even Cloud eventually - and use that cash to buy back stock.
I think there is time for Google to catch up on the tech side in terms of their consumer-facing AI products, because this is not going to happen overnight. Also, whatever Google offers may only need to be "good enough" to hold share, since people are used to going to Google. It's a reflex, it's a habit. So Google Search may not have to be the best, it may just need to be good enough, because Google Search is overwhelmingly the incumbent for people's information needs.
Wall Street tech analysts tend to be tech enthusiasts. The Google bears calling for the death of Google Search have spent tons of hours down the rabbit hole of not only ChatGPT and Bard, but also all the competitors. The average person has not done that. The average person is time-starved, at best a fast follower of technology, and really just wants to get their sh*t done as quickly as possible. For people to abandon Google Search for some new alternative, that new alternative is going to need to be obviously superior after 5-10 minutes of use, not after 2 hours or 2 days of learning and practicing it. Because you don’t fix what isn’t broken, especially when it is free.
A lot of people are worried about there being less room for ads in whatever format search evolves into, once AI is fully integrated. That’s a reasonable concern as well, but I also think advertisers need customers and they have a budget to go find those customers. If there are fewer ads available, my guess is that each ad will end up costing more. The Super Bowl is the ultimate example of this. So if Google can hold the users, they can hold onto the ad dollars. So I am worried about search/information seeking market share, but less concerned with how the page ultimately ends up looking.
No one knows what will happen for sure. It’s all conjecture, like it often is in investing (even though no one wants to admit that). My money is still on the Goog.
I will try to talk about my other pick for 2024 next time.
Quick Notes from the ICR Conference
During the second week of January, I traveled to Orlando to attend ICR, a consumer-oriented conference attended mostly by small cap consumer companies, plus a few bigger ones, as well as lots of privately held, venture- and private equity-backed consumer companies. Plus there are tons of investors, bankers, and assorted deal makers wandering around. I’ve been going to this conference for about 20 years, and it is always a whirlwind and I always learn a lot.
I meant to write a whole post about the conference, but life got in the way. But I will share some top takeaways:
1. The consumer is still very healthy. Shockingly resilient. While people may tell pollsters they think the economy is bad, their actions are speaking very differently from their words. People are spending.
2. While people are spending, they want what they buy to be a deal. Consumers were extremely reactive to promotions over the holidays, especially when shopping online. No one wants to pay full price, and when companies pulled back on the promotions, transactions slowed.
3. Everyone is waiting for the next shoe to drop. It’s been a soft landing so far, and there is a sense it’s too good to be true. So management teams are planning conservatively for the future, even though there have been no warning signals flashing yet.
4. Walmart’s Chief Marketing Officer William White gave an interesting presentation highlighting the rising importance of media and retail media in how Walmart gets shoppers to transact. Examples included its Black Friday “Mean Girls”-themed promotions, featuring three of the 2004 film’s original cast, and the 23-bite sized episodes of the shoppable romcom it launched for the holidays, Add to Heart, which got over a billion impressions in its first week.
5. There were a lot of jokes about 11-year-old girls with Stanley water tumblers, Uggs, and a passion for skincare at Sephora. Having one of these at home, I feel seen.
Some Interesting Things I Read Recently
Inside Walmart’s New Shoppable ‘RomCommerce Series and What It Harbingers for Brands”
Inc., 11/30/2023
More on Walmart’s click-to-buy holiday media endeavor.
YouTube, December 2023
So you can see what we are talking about.
Walmart’s Mean Girls Reunion/Black Friday Ad
YouTube, November 2023
I first saw this on TikTok and later on Reels. CMO William White, who has been on plenty of ad shoots during his years in leadership at Walmart, Target, and Coca-Cola said he had never seen more paparazzi at a shoot than he did at this one, which was kept heavily under wraps. Even people who work in marketing at Walmart did not know this was coming. Nostalgia 10/10.
Pinterest 2024/The Trends of Tomorrow Today
Pinterest, January 2024
There are likely some investment ideas buried deep in here. Still working through it myself. Spoilers: the blue eye shadow of my middle school years is making a comeback, badminton is coming for pickleball, and gummy candy kabobs are a thing (so are cheeseburger tacos and pizza pot pie).
Super Bowl LVIII Odds: Potential Taylor Swift Prop Betting Markets
SI.com, 1/29/2024
If the regulators will allow it, DraftKings (DKNG) is coming for the Swifties, who will have their chance to play stupid games and win some cash (as opposed to stupid prizes – IYKYK).
Sports Illustrated’s Strange Merger
Bloomberg, 1/23/2024
Speaking of Sports Illustrated, the future of the 70-year-old magazine is hanging in the balance due to some very shady deal making. The saga of a rogue billionaire and poor corporate governance.
Dead and Company Confirm Return With Las Vegas Sphere Residency
Rolling Stone, 1/31/2024
A little more than six months after the last date of “The Final Tour”, the Grateful Dead spin-off band announced that they would play a series of dates at the Sphere, which I wrote about in December. I guess technically this is not a tour, it’s a residency. Semantics… but good news for the folks at the Sphere, who need to book those dates.
Money Show, 1/8/2024
In case you don’t want to wait to hear my other top pick for 2024 (although it is a name that should be familiar to regular readers). The report is free and includes 91 recommendations from 53 contributors. They run the gamut from conservative, quality blue chips designed to generate safe and steady returns to high-growth stocks with massive potential upside (and correspondingly, more risk).
Prosperous Investing!
Disclaimer: This content is for informational and educational purposes only and does not constitute financial advice or a recommendation for a particular investment.
Disclosure: The author may have a personal financial interest in the securities mentioned. At the time of publication, personal investments included GOOGL, AAPL, and META.
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