Morning Note: Market news and updates from Alphabet (Google) and Microsoft.
Market News
US equity markets moved lower in last night’s session – S&P 500 (-0.5%), Nasdaq (-0.6%) – although they rose after hours on the back of strong corporate earnings from Alphabet and Microsoft (see below). The positive mood followed on into Asia this morning in Asia: Nikkei 225 (+0.8%); Hang Seng (+2.3%); Shanghai Composite (+1.1%). The yen weakened further to 156 to the dollar after the BOJ failed to provide any concrete guidance on JGB purchases. The key rate was kept unchanged as expected.
After yesterday’s outlying rise, the FTSE 100 is currently trading a further 0.6% higher this morning at 8,126. Anglo American has released a response stating that it believes the proposal from BHP significantly undervalues the company and its prospects and contemplates a structure which is highly unattractive for AAL’s shareholders. The board has therefore unanimously rejected the proposal. The shares rose 16% yesterday, well above the implied value of the bid, suggesting the potential for an improved offer or an approach from a third party.
This comes against a backdrop of ongoing geopolitical tension, with Israel is preparing for an escalation in the conflict with Hezbollah as it bolsters military exercises in the north. Both the oil price ($88.30 a barrel) and gold ($2,339 an ounce) moved higher. Treasuries steadied – the 10-year yields 4.68% – after overnight losses, with traders looking ahead to the release today of the Fed’s preferred inflation gauge for March.
UK Consumer Confidence increased as inflation and taxes all. The GfK sentiment gauge rose by two points to minus 19 in April. The researcher urged some caution as hopes of a summer interest-rate cut recede. Sterling currently trades at $1.2507 and €1.1658.
The ECB may have to return to ultra-low rates if cuts aren’t made soon, Fabio Panetta said. The euro area needs fresh impetus from easing and a lack of loosening at the Fed shouldn’t pose an obstacle. “Timely action would allow the ECB to be nimble and move in small, progressive steps,” Panetta said.
Source: Bloomberg
Company News
Last night, Alphabet released quarterly results which were better than market expectations. The company also declared its first-ever cash dividend and increased its share buyback programme by $70bn. In response, the shares were marked up by 12% in after-hours trading.
Alphabet is the public holding company for Google, one of the world’s most recognised and widely used brands. In addition to the core search engine, the group owns digital video platform YouTube, Google Cloud, web browser Chrome, mobile operating system Android, Gmail, Google Maps, Fitbit, and autonomous driving company Waymo, among others.
The group has a strong track record of innovation, leaving it well placed to capitalise on a wide variety of technological themes, such as digital media, e-commerce, video advertising, the cloud, the internet of things, driverless cars, and artificial intelligence. We believe the shift to internet-connected devices and streamed TV means the growth of advertising dollars on Google Search and YouTube has much further to run. Machine learning capabilities should also help advertisers get higher return on investment and encourage them to continue to allocate their advertising budgets to Google. The company currently has a global digital ad market share of 28%.
The company has six products with more than two billion users each and another nine with more than 500m users, most of which are far from being fully monetised. The group’s structure allows it to own a portfolio of businesses with different time horizons, while its broad offering provides a competitive edge. Capital allocation is strong and spread across internal R&D, accretive M&A, and massive shareholder returns.
In the three months to 31 March 2024, revenue grew by 16% on a constant currency basis to $80.5bn, ahead of the consensus forecast of $78.6bn. The main drivers were strong performance from Search, YouTube, and Cloud.
The group reports its results across three segments: Google Services, Google Cloud, and Other Bets. Google Services is the largest division (87% of revenue), generates revenue primarily from digital advertising and the sale of apps, digital content products, hardware, and YouTube subscription fees. During Q1, Google Services revenue grew by 14% to $70.4bn.
Google Search (which accounts for 75% of ad revenue) increased by 14%. Advertising from Google Network Members’ websites (12% of ad revenue) fell by 1%. The group separates out YouTube, which accounted for 13% of ad revenue in the quarter and grew by 21%.
Other sales within the Services division (known as Google Subscriptions, Platforms, and Devices) include Play, content products, hardware, service, licensing fees, Nest, and YouTube’s non-advertising revenue. They grew by 18% in the quarter to $8.7bn.
Traffic acquisition costs (TAC) are the fees Google pays to other companies (such as Apple) to carry its search service and adverts (i.e., cost of sales). During Q1 they grew by 10% and currently account for 21% of advertising revenue.
Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Fee revenue comes from Google Cloud Platform services and Google Workspace (formerly known as G Suite) collaboration tools. In Q1, Cloud grew by 28% to $9.6bn, an acceleration from the mid-20s growth rate in the previous quarter. Growth is being driven by AI adoption. Although the group continues to invest to grow the cloud business, the division’s quarterly profit grew from $191m to $900m.
The group’s Other Bets division (less than 1% of revenue), which is effectively an incubator fund for new products and technologies, made a quarterly loss of $1,020m. The group has wound down non-priority projects.
Alphabet continues to ‘durably engineer’ its cost base to support its investment in long-term growth opportunities, most importantly AI. Spending on data centres to support its AI plans is forecast to jump this year.
The number of employees fell by 5% year-on-year. In Q1, the group took an employee severance charge of $0.7bn, which is on top of the $2.1bn taken in 2023. Actions are also being taken to optimise global office space and use AI to increase business productivity.
In the latest quarter, group costs and expenses increased at a slower rate than revenue (+5%). As a result, margins expanded sharply from 25.0% to 31.6%. EPS grew by 62% in the quarter to $1.89, well above the consensus forecast of $1.51.
Free cash flow generation was strong ($16.8bn in the quarter), despite ongoing spend on R&D and capex, while its huge cash pile (including marketable securities and long-term debt) stands at $98bn. This has allowed the group to significantly increase its capital return to shareholders. During the latest quarter, the company bought back $14bn of its shares and has announced another $70bn repurchase programme.
In addition, the group has also approved the initiation of a cash dividend programme and declared a dividend of $0.20 per share. The company intends to pay quarterly cash dividends in the future. This is positive news and puts the company on an equal footing with Microsoft and Apple in the minds of investors looking for yield.
Although advertising is cyclical, we believe Google will show relative resilience as advertisers, evaluating the effectiveness of their budgets, migrate to platforms with the most scale, measurability, and demonstrable return on investment.
Regulators are increasingly focused on the depth and form of user data that are collected and used to target ads. As a result, political/regulatory risk remains elevated, with the potential for large fines, forced changes to business practices, or a break-up. However, we believe any action could be years away.
AI remains a hot topic. We believe the Alphabet is well placed – the company has been incorporating AI functionality into its search capabilities and other products for years and is expected to launch a steady stream of innovation in the future. Furthermore, Google’s position in cloud services – it is one of the big three public providers – leaves it well placed to provide the infrastructure and computing power needed by AI, while the group’s user scale and usage frequency supports a wealth of data, providing another competitive advantage. However, the introduction of Gemini, the group’s most advanced AI model, which is capable of more sophisticated reasoning and understanding information with a greater degree of nuance than its prior technology, has been plagued with issues. This has raised concerns regarding execution and company’s ability to compete in an area of technology that Google itself pioneered. The group’s latest quarterly results are helpful in this regard. In addition, last month Apple was rumoured to be in talks with Google about building Gemini into the iPhone.
Looking forward, although the economic outlook will remain somewhat of a headwind in the near term, the group is facing easing year-on-year comparatives in 2024. Alphabet continues to trade on a valuation (20x ex-cash) below most of the other tech majors and at a level we believe is very attractive for a company exposed to several areas of long-term secular growth.
Source: Bloomberg
Last night, Microsoft released results for the three months to 31 March 2024, the third quarter of its financial year to June 2024. The figures were ahead of market expectations and the shares rose by 4% in after-hours trading.
Microsoft is a global leader in consumer and enterprise software, services, devices, and solutions, leaving it well placed to benefit from the ongoing shift to digital technology and several other secular trends. In an inflationary world, digital technology provides a deflationary force to help business offset cost pressures elsewhere. The group’s competitive edge lies in the strength and breadth of its portfolio of resilient and trusted technology which provides unique integration of its cloud-based products and services, covering productivity apps, infrastructure services, security, and communications. The group’s offering includes Windows, Microsoft 365 (formerly Office), Skype, Hotmail, LinkedIn, Bing, GitHub, Surface, Xbox, and OpenAI ChatGPT. Not only are the group’s products designed to work together but, for the customer, it is also more economical to bundle multiple products.
Its portfolio is being continuously enhanced through in-house product development and acquisitions, allowing the company to push through price increases and sell new products and services to a growing base of consumers – in the past few years, gaming, security, and LinkedIn, have all surpassed $10bn in annual revenue. In addition, as one of the world’s three largest cloud companies, Microsoft Azure is benefitting from the migration of workloads from on-premise to public cloud platforms, a transition that we believe has a long way to go. With its stake in OpenAI and its agreement to be their exclusive cloud provider, Microsoft is well placed in the world of AI. Most recently, the group has released the Microsoft Windows Copilot, the AI assistant tool.
The group operates a user subscription model which generates a visible, long-term annuity revenue stream with higher margins and strong cash flow. In FY2023, the group generated revenue of almost $212bn (up 11%), gross margins of 69%, and operating margins of 42%. Microsoft has a very strong balance sheet and in addition to reinvesting cash back into high growth opportunities and M&A, the company has consistently increased its dividend and is repurchasing its own shares.
During the latest quarter, revenue grew 17% at constant current (CC) to $61.9bn, a touch better than the consensus forecast of $60.8bn.
· Productivity & Business Processes generated revenue of $19.6bn, up 11%, versus company guidance of 10%-12%. Growth was driven by Office 365 Commercial (+15%) and Dynamics 365 (+22%).
· Intelligent Cloud generated revenue of $26.7bn, up 21%, above the company guidance of 18%-19%. Growth was driven by Azure (+31%). Microsoft Azure’s is outperforming the other cloud providers due to its greater exposure to enterprise and hence, potentially more resilience, and its better positioning around AI workloads.
· More Personal Computing generated revenue of $15.6bn, up 17%, above the company guidance of 11%-14%. Growth was driven by Xbox content and services (+61% due to the Activision acquisition), partly offset by a decline in devices (16%).
The gross margin rose one point to 70%, driven by a sales mix shift to higher margin businesses. Operating expenses only grew by 10% and, as a result, the operating margin rose by two points to 45%. EPS grew by 20% at CC to $2.94, above the market forecast of $2.82.
The group generated strong free cash flow, up 18% to $21bn in the quarter, reflecting higher capital expenditure to support cloud and AI offerings. Microsoft is expected to spend heavily on capex this year – up 40% to $40bn or 16% of revenue. Much of this will be spent on new AI chips and high-performance networking for its datacentres.
Net cash ended the quarter at c. $15bn. The company is authorised to repurchase up to $60bn in shares, with $2.8bn bought back in the latest quarter. The company also paid out $5.6bn in dividends.
On the analysts’ call, the group provided guidance for the current quarter. By division, revenue in Productivity and Business Processes is expected to grow by 9%-11%, Intelligent Cloud by 19%-20%, and More Personal Computing by 10%-13%.
We believe in the current environment the company faces a relatively lower level of political risk and should prove more defensive during the current economic uncertainty.
Source: Bloomberg