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Alphabet earnings: Advertising revenue growth disappoints

In mixed set of results, we raised our fair value estimate based on higher revenue and margin forecasts.

Mentioned: Alphabet Inc (GOOGL)

Key Morningstar metrics for Alphabet

  • Fair Value Estimate: $171.00
  • Morningstar Rating: 3 Stars
  • Morningstar Economic Moat Rating: Wide
  • Morningstar Uncertainty Rating: High

What we thought of Alphabet’s (NAS: GOOGL) earnings

The network effect continued to drive growth at Google search and YouTube during the fourth quarter. In addition, as we expected, increasing demand for artificial intelligence accelerated cloud revenue growth. However, continuing weakness in Google’s advertising technology business, or Google network, pressured total advertising growth a bit.

We expect further declines in the network segment this year and next, as we still think that Google’s owned and operated properties remain the top priority for advertisers. We also believe that more advertisers will likely use non-Google ad-tech platforms when they purchase on non-Google properties. This has been a trend for more than 10 years, during which network revenue has declined to 13% of total advertising revenue from nearly 23%.

We have increased our revenue projections for Alphabet GOOGL as the acceleration in cloud revenue growth, further monetization of YouTube, and the continuing steady growth in search likely will more than offset the impact of declining network segment revenue. In addition, we have increased our margin assumptions through 2028, given the cloud segment’s margin expansion and the success of the firm’s overall cost control and efficiency efforts. Our model adjustments result in a $171 fair value estimate, up from $161.

Alphabet reported total fourth-quarter revenue of $86.3 billion, up more than 13% from last year. The growth in search (13%) and YouTube advertising (16%) more than offset the 2% decline in network revenue. Cloud growth accelerated year over year to 26% from 22.5% in the previous quarter as the number of cloud clients and usage per client increased. Strong subscriber growth in YouTube Premium, YouTube TV, YouTube Music, and Google One drove the 23% growth in Google’s other services revenue.

The operating margin expanded more than 350 basis points from the same quarter last year to 27.5%, resulting in an operating income of $23.7 billion.

Business strategy

Alphabet dominates the online search market with 90%-plus global share (80%-plus U.S. share) for Google, and the business generates very strong cash flow. We expect continuing search growth as we remain confident that Google will maintain its leadership despite Microsoft moving first to include generative artificial intelligence in Bing search. We also foresee YouTube and cloud contributing more to the firm’s top and bottom lines. Finally, we view investments in “moonshots” as attractive, with significant uncertainty but also substantial upside.

Google’s ecosystem strengthens as its products are adopted by more users, making its online advertising services more attractive to advertisers and publishers and resulting in increased online ad revenue. We think ad revenue can continue to grow at high-single-digit rates during the next five years.

The firm utilizes technological innovation to improve the user experience in nearly all its Google offerings, while making the sale and purchase of ads efficient for publishers and advertisers. Adoption and usage of mobile devices has been increasing. The online advertising market has taken notice and has followed its target audience onto the mobile platform. We have seen Google partake in this on the back of its Android mobile operating system’s growing market share, helping it drive revenue growth and maintain its leadership in the space.

Among the firm’s investment areas, we particularly applaud the efforts to gain a stronger foothold in the fast-growing public cloud market. Google has quickly leveraged the technological expertise it applied to creating and maintaining its private cloud platform to increase its market share in this area, driving additional revenue growth and creating more operating leverage, which we expect will continue.

Most of Alphabet’s more futuristic projects are not yet generating revenue, but the upside is attractive if they succeed, as the firm is targeting newer markets. Alphabet’s autonomous car technology business, Waymo, is a good example: Based on various studies, it may tap into a market valued in the tens of billions of dollars within the next 10-15 years.

Moat rating

We assign Alphabet a wide moat rating, thanks to durable competitive advantages derived from the company’s intangible assets, as well as the network effect.

We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and artificial intelligence (machine learning and deep learning), as well as access to and accumulation of data that is deemed valuable to advertisers. We also believe that Google’s brand is a significant asset; "Google it" has become eponymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry. While with Microsoft’s Bing is attempting to dethrone Google with AI technology from OpenAI, we think the firm can defend its dominance in search with its own AI technology, some of which OpenAI’s products are based on.

In our opinion, Alphabet’s network effects are derived mainly through its Google products such as Search, Android, Maps, Gmail, YouTube, and more. Ultimately, we view Google’s network as heterogeneous. On the one side, all the products Google offers have provided it with a massive consumer base that allows the company to collect data. On the other side, via its rich collection of data and large user base, Google can offer the best return on investment for advertisers and build a growing network of advertising customers. The addition of each new ad and advertiser improves the efficiency of Google’s programmatic advertising offerings, allowing the firm to better monetize the network.

In search, Google has successfully and consistently monetized many of its technology-based intangible assets, from the original algorithms behind search to the current machine learning ones and the deep learning-based generative artificial intelligence (generative AI), which are also being applied to nearly every product. The company was recognized first for its "extremely relevant results" by PC Magazine in December 1998.

From that point, it grew into the world’s most popular online search engine and has maintained its leadership. Google processes more than 3 times and 4 times as many search requests as Bing (Microsoft) and Yahoo, respectively. Google Search’s success stems from the relevance of its results to its users and the likelihood that this relevance will improve as more data is gathered and analyzed, assumptions are generated, and predictions are created. Google has used machine learning technology to improve the user experience.

The company has applied machine learning to Search (speech recognition), Gmail (Smart Reply), Google Photos, Maps, and many other products, including its cloud offerings. As technological advancements improve the user experience for each product, the likelihood of further usage increases. The firm is also applying generative AI to enhance its search engine’s communication and response with users. Products with those features include Bard and the Search Generative Experience, or SGE, which the firm is testing in its Search Labs.

With generative AI in search, while clicks will likely decline, the search engine will have more data regarding user’s interest, which it can use for contextual campaigns for advertisers.
Based initially on its technology, Google has successfully increased its users’ dependence on its products to keep transforming the usage of those products into something habitual. We have seen that with online search, as most people around the world continue to "Google it." It has strengthened its brand, which we think has longevity. We view the Google brand as a significant driver of user growth for YouTube, Maps, Gmail, and Chrome. Again, an expanding user base helps the company collect more data, which is monetized when applied to online ads.

Google search’s large and growing user base has created a network difficult to replicate, in our view. We believe that an additional search on Google’s search engine creates value for other users, as well as for advertisers and businesses. With AI (machine learning and deep learning) technology, more requests made by current and/or new users improve relevancy of search results, creating value for users. More relevant results also decrease the likelihood of users jumping to another search engine, creating somewhat of a barrier to exit.

For advertisers, value is created mainly through growth of the large user base to target and from behavioral data compiled and analyzed. As users and search requests grow and more data is gathered, advertisers’ demands for ads increase, helping Google to further monetize the network. We think this can be strengthened in the long run with the application of generative AI.

As with Google Search, we see network effects from large and growing user bases of other products, such as Maps, Gmail, and Chrome, all of which create value for users and advertisers. As more consumers use Maps, more data regarding traffic, commuting tendencies, and so forth is gathered, helping Google generate more accurate results (in terms of locations, travel times, and route suggestions). Google also utilizes such data to provide faster routes. Businesses and advertisers pay Google to place their search ads, targeted based on users’ locations and previous searches, within Maps’ search results list and directly on the map.

Google's Chrome browser remains the market leader with nearly a 63% share, according to StatCounter, compared with over 20% for Apple's Safari and 5% for Microsoft's Edge. In our opinion, growth in Chrome browser usage helps increase the network effect for Google. In addition, by launching Android in 2007, Google positioned itself well in the faster-growing mobile ad market, maintaining its online search dominance and strengthening its network effect. According to IDC, Google’s Android OS powers more than 87% of smartphones around the world, compared with Apple iOS' slightly over 12%. With Google’s Chrome browser on Android phones, more mobile searches are conducted using Google. We note, however, that Google makes annual payments to Apple and Samsung for its search engine to be the default option on their mobile devices.

Android’s network effect also creates more value for users. As the number of Android-powered smartphones increases, more developers will create more apps to be made available on Google Play and run on those smartphones, creating additional value for Android smartphone users.

We think YouTube is also valuable, as it benefits from a network effect that creates value for users, content creators, and advertisers. With more viewers on the site today, more content creators will look to YouTube for content distribution. Continuing growth of YouTube’s content library drives further viewer growth. YouTube’s video platform has more viewers than other online video properties, making it attractive for advertisers.

We expect Google to gain a foothold in the growing enterprise cloud market, but we do not think its cloud offerings create a network effect. Although Amazon is clearly the leader in this space, we expect Google to gain further traction and trail only Amazon Web Services and Microsoft’s Azure in market share. Ultimately, we believe Google can leverage the technological expertise (including machine learnings and deep learning AI) it applied to creating and maintaining its private cloud platform to build and maintain public cloud platforms for many businesses.

Regarding other potential moat sources, we do not believe Alphabet has a durable cost advantage when compared with its peers. Alphabet’s size allows it to invest heavily in Maps and YouTube, and perhaps in more capital-intensive businesses like enterprise cloud or Google Fiber. However, we don’t see an inherent cost advantage in Alphabet that other tech titans like Apple and Amazon can’t replicate, especially since cloud hardware is becoming increasingly commodified.

We believe that customer switching costs provide Alphabet with only a negligible competitive advantage. Alphabet’s Google offerings, such as search, YouTube, Android, Maps, and Gmail, have some switching costs associated with time and effort needed to learn a new user interface, move content to another platform (YouTube) and notify contacts of an email change (Gmail), but such costs are not so prohibitive that these customers are locked in forever.

Finally, while Alphabet generates economic profit through Google, which we think will continue, this profit would be higher were it not for Alphabet’s efforts to remaining a step ahead in terms of innovation. In its other bets segment, Alphabet is betting on (or investing in) using technology to enhance health (Verily), self-driving cars (Waymo), and much more. Some of these wagers may not bring in any winnings, and we believe it is too early to consider these businesses as contributors to Alphabet’s economic moat, either in terms of intangible assets or network effects.

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