Google Q2 2018: AI And Cloud Driving The Show

  • After Q1 2018, we argued that earnings power was accelerating at Google, and called it a no-brainer buy at $1,000/share.
  • We dissect Q2 results, going beyond reported financials.
  • We share our main takes from the earnings conference call.
  • We update on the investment thesis and recommendation.

Alphabet (GOOG) (GOOGL) is part of the one-of-a-kind IW Portfolio since the Q1 2018 earnings report.

In our initial piece on Alphabet, with the Street worrying about decreasing margins and outsized capital expenditures, we looked beyond reported financials and concluded:

Contrary to the prevailing market sentiment, we believe that Alphabet's economic earnings growth is actually accelerating [...]

At $1000/share, we estimate that Alphabet is trading at about 1.25x Earnings Power Value (ex-cash and without "Other Bets"), that is, at a 25% premium of the net present value of the cash flows to shareholders, had management decided to stop investments in growth and distribute all FCF [...]

Hence we see the $1000/share price as very compelling. So compelling that it raises the question of how the market is missing it. 

Two weeks later, we went even further and advanced Alphabet's forward earnings power yield (5.5% at the time) as the opportunity cost of tech investments.

Today, following a Q2 report in line with our expectations, the stock is up some 25%. And quite frankly, nothing has really changed. So much for market efficiency.

In this piece, we comment on the main takeaways from the earnings report and conference call and update on the investment thesis.

Sundar Pichai, CEO of Google (source: wccftech)

The numbers


In Q2 2018, Alphabet delivered another strong top-line quarter, with FX-neutral revenue up 23% YoY, just as in Q1.

By segments and before FX adjustment, Google advertising revenue was up 24%, led by mobile Search and YouTube; Google other revenue, up 37%, driven by Cloud, HW and Play; and Other Bets were up 40%.

Operating income

Reported operating income grew 14.7% YoY to $7,878 million, with 230 bps of operating margin compression to 24.1%, due to a 260 bps gross margin hit, partially offset by operating leverage.

These and the following numbers are before accounting for the European Omission Commission fine of €4.34 billion (about $5.1 billion) related to certain contractual provisions in agreements between Google and Android partners. We deal with the impact of the fine later.

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Disclosure: I am/we are long GOOG (see all the current holdings in the IW Portfolio).

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Investment Works 3 years ago Author's comment

For those of you that didn't know us :

you can subscribe to the IW Newsletter to learn about all future stock picks and research:

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It is free in 2018 and offers lots of actionable ideas.

Carol D. Richards 3 years ago Member's comment

So you really thing Google will be the one to win the AI race?

Investment Works 3 years ago Author's comment

Hi Carol,

There will be many winners, and Google has everything on its favor to win big time.

Not only have they taken an early lead in deep learning academic research (as measured by contributions to key conferences, deep mind's achievements, etc.), but they also have the data and go-to-market platforms to capitalize that lead commercially (think Search, Android, Play, Maps, YouTube...).

The question is how well will they monetize those advantages. Admittedly, there are better executors than Alphabet management, but the advantages are so many and the stock price so moderate as to provide compelling risk-reward, in our view.