Google's Q2 Earnings Beat Expectations, But Stock Falls: Analyzing the Paradox

Google Stock: Amazing Earnings, Poor Market Reaction (Upgrade) (NASDAQ:GOOG)

Looking for a helping hand in the market? Members of Beyond the Wall Investing get exclusive ideas and guidance to navigate any climate. Learn More " My first and so far only article about Alphabet Inc (NASDAQ:GOOG) (NASDAQ:GOOGL) was published in mid-March 2024 with a 'Hold' rating. At that time, I wasn't sure if it was the right moment to buy Google stock because I was concerned about the potential negative sentiment surrounding Gemini. However, I noted back then that the company looked cheaper than other mega-cap companies in the market, considering the implied growth rates and multiples. I suggested waiting for the results of Q1 2024 before making any definitive conclusion. As time has shown, Google reported very strong results for Q1, which allowed its stock to grow significantly, beating the broader market: As I write these lines, the company announced its results for Q2 2024 just a few hours ago and commented on them at the earnings call. Based on the after-hours market reaction, however, we see that despite strong beating in terms of both EPS and sales, the stock is falling by more than 2% following the management's comments. However, from what I see, it seems that my concerns described in the last article have become less relevant. The company continues to grow despite seemingly difficult competition, while remaining relatively cheap compared to other mega-cap companies. So based on this, I feel that I should upgrade my rating to 'Buy'. Let's take a closer look at Google's results for its most recent reporting period, Q2 2024. Revenue growth in Q2 2024 amounted to 14% year-on-year, or 15% YoY adjusted for FX changes (i.e. in constant currency). Compared to last year, revenue growth has definitely accelerated, almost doubling. Notably, EBIT grew by 25.6% year-on-year against the backdrop of rapid growth in margins in the Google Cloud segment (EBIT from this segment went up by 196% YoY). While operating losses from 'Other Bets' and 'Alphabet-level activities' became even larger, the increasing margins in Google Cloud and Google Services allowed the company to increase its consolidated operating margin from 29% last year to 32% this year - that's a 300 basis point increase in just one year, alongside revenue growth of 15%, as I've already noted. These strong quarterly results, achieved against a backdrop of virtually flat operating costs in absolute terms, led to diluted EPS increasing by 31.25% year-on-year. As mentioned earlier, this was more than enough to beat the consensus forecast for Q2 2024. In my last article, I noted that the company's operating margin was stagnating, which led me to believe that a further rise in the stock price was unlikely (because of the historical correlation of these two metrics). However, as practice over the last two quarters has shown, this assumption was incorrect. The company's margins have risen sharply due to the measures previously implemented to reduce OPEX. One of the most important events last year was the reduction in the number of employees. According to the press release, in Q2 2024, the total number of employees worldwide amounted to ~179.5 thousand people, which is 1.2% less than in the same period last year; and I believe the number of employees may continue to fall in the future. As announced in April, Google is working to consolidate its teams to focus on developing AI models in different departments. Therefore, I believe that the development of these technologies will lead to a clear reduction in headcount, positively affecting the OPEX. Speaking about prospects for further development of Google's margins, I think that what we saw in terms of Google Cloud is just the beginning. This segment crossed the $10 billion mark in revenue for the 1st time in its history, with $1.2 billion in operating profit. The GC's revenue share amounted to 12.2% in Q2 - that's 143 b.p. more than a year ago. However, the current EBIT of this segment is only ~11.5%, which is very small compared to Amazon's (AMZN) AWS, which has a margin of ~37.6%. I think that just due to organic growth, Google Cloud can potentially double its current EBIT margin even without taking into account potential revenue growth (which is still there). The potential positive impact on the company's consolidated operating profit, therefore, may be enormous in the future. I propose to make a hypothetical calculation here. Let's assume that today's forecast revenue for 2025, amounting to ~$386 billion, is correct. If Google Cloud's revenue share grows by another 140 basis points YoY, then the top line of this segment could amount to ~$52.5 billion in the full year 2025. If the expansion of GC's EBIT margin continues and grows from the current 11.5% to, let's say, 15% (which, in my opinion, is feasible), then by the end of 2025, Google Cloud could earn up to $7.9 billion in operating profit according to my calculations. This is more than 4 times what this segment brought in in FY2023 - and this assumes a relatively modest pace of expansion. That is why I'm not very concerned about the weakness in the Google Networks segment - the revenue contribution from this segment is now less than that from Google Cloud, and so its impact on the overall consolidated top line is declining quarter by quarter. As we learned at the earnings call, all 6 Google products with more than 2 billion monthly users now use Gemini, and Google plans to integrate AI into other products and services such as Search, Workspace, Google Messages, Gmail, and Google Photos. The company's heavy investment in infrastructure to support its AI efforts, including the development of new generations of TPUs (Tensor Processing Units) and partnerships with companies such as Nvidia (NVDA) for advanced AI hardware, while seemingly extensive and costly, should ultimately result in Google maintaining its supremacy in Search and having great opportunities in other areas as well, in my opinion. Also, some concerns about the potential negative impact of widespread AI adoption on margins have somewhat diminished following the second quarter results, as the company has successfully managed to keep operating costs flat. This suggests that the integration of AI may not necessarily lead to significant margin erosion, as some had initially feared. We continue to invest in designing and building robust and efficient infrastructure to support our efforts in AI, given the many opportunities we see ahead. Of course, as we do this, we'll continue to create capacity by allocating resources towards our highest priorities. We are relentlessly driving efficiencies in our AI models. For example, over the past quarter, we have made quality improvements that include doubling the core model size for AI overviews, while at the same time improving latency and keeping cost per AI overviews served flat. And we are focused on matching the right model size to the complexity of the query in order to minimize impact on cost and latency. The market agreed with my above findings, giving Google strong future projections (even before Q2 results). Wall Street consensus prices in a CAGR expansion in EPS of over 15% for the next 6 years, which I think are very impressive numbers for a company of such a large size. Despite persistently high growth rates in EPS, Google's current valuation appears conservative when considering long-term multiples. Based on consensus estimates, the company is trading at around 10 times its net earnings expected for FY2029. While this may seem like a distant future, a comparison of Google with other companies of a similar size reveals that the undervaluation I discussed in my March article persists, and may even have increased, despite Google's stock price having risen by almost 30% since then. To illustrate this, let's look at a chart where the y-axis represents the long-term price/earnings multiples, and the x-axis represents the projected growth rates (CAGRs) for the next few years (up to 2030). As you can see, Google clearly stands out in this comparison. Its growth rate is 145 basis points above the median of the sample, while its long-term P/E multiplier is ~36.5% lower than the median of the analyzed sample. So this primitive analysis suggests that Google remains one of the most attractive companies among the FANGMAN companies. Based on the comprehensive analysis presented above, I believe it's appropriate to upgrade Google's rating from 'Hold' to 'Buy' today. I acknowledge that my article may not delve deeply into the reasons behind the after-hours decline in the stock price amid the strong earnings report. It appears the market is concerned about the company's substantial CAPEX and the significant increase in spending on Waymo, Google's self-driving car unit. Alphabet CFO Ruth Porat said the Google parent company will invest an additional $5 billion into its self-driving car unit Waymo. The announcement comes on the heels of the company's second citywide expansion in San Francisco. Although the company has bought back more shares than some analysts had expected (Goldman Sachs, proprietary source, July 2024), investors would probably rather see even more buybacks and dividends than investments in projects that many consider questionable and outside the company's core business. The risk is that if costs for this business segment continue to grow, we may face a situation similar to Meta's (META) experience with the metaverse, which led to a significant decline in its shareholders' value at some point. On the other hand, Google risks losing part of its market share in various end-markets because competition has been growing rapidly in recent months, driven by innovations in generative artificial intelligence. Despite the risks mentioned above, I was impressed by the report for the second quarter of 2024. The company's consolidated revenue continues to grow, and the key business segments are showing excellent growth in terms of operating income and margins. In addition, I believe Google still has significant potential, particularly in Google Cloud margins. So I'm now convinced that the company will be able to further increase its consolidated margins in the foreseeable future, which justifies the significant stock price increase in recent months. In addition, GOOGL is still very attractively valued compared to most other mega-cap companies. Even if industry affiliation plays a role, the higher projected growth rates of Google's EPS compared to the median of the analyzed group of companies indicate that the company is undervalued by about a third (compared to the median). This leads me to conclude that Google is too cheap to ignore. I've therefore decided to put aside my earlier doubts and raise my rating to 'Buy' despite the muted after-hours reaction of the market.

Here's Why Google Fell Despite The Q2 2024 Earnings Outperformance (NASDAQ:GOOG)

However, the stock's post-earnings response continues to highlight the increasing disparity between Google's fundamental outlook and its valuation premium at current levels. Google (NASDAQ:GOOG/NASDAQ:GOOGL) has been one of the biggest gainers this year, alongside digital advertising peer Meta Platforms (META). Previous concerns over potential cannibalization of Google's online search dominance with the advent of generative AI tools like OpenAI's ChatGPT have largely subsided. Google's continued demonstration of resilience at its core search advertising and Google Cloud segments are also buoying the stock's upsurge towards all-time highs. The company's recent roll-out of AI Overviews to supplement native search results on Google is also in line with our previous expectations for further monetization of Search Generative Experience ("SGE") developments. This was evident in the sequential acceleration in Google Search & Other revenue growth during Q2, which expanded at +5% q/q to $51.1 billion, despite softness in seasonality. Specifically, Google's outperforming results in Q2 continue to corroborate its capabilities in monetizing the substantial AI investments that have been and are still being made. The company's consistent positive progress in growing core search advertising and Google Cloud revenues, while maintaining profit margins by balancing incremental AI-related costs have also played a key role in alleviating previous investors' angst over competitive threats. Yet, we see limited new catalysts in the near-term that could enable further multiple expansion for Google's stock from current levels, as AI monetization opportunities through its core advertising and Google Cloud segments are likely already priced in. Google Search advertising and Google Cloud remain key focus areas. Management has continued to emphasize Google's strategy in integrating generative AI capabilities into its core operating segments in order to capture relevant emerging growth opportunities. However, we believe the realization of incremental AI-driven monetization opportunities across Google Services and Google Cloud have already been priced into the stock at current levels. Specifically, supporting underlying fundamental estimates likely already reflect the incremental growth outlook and efficiency gains stemming from Google's AI strategy earmarked for its core search advertising and Google Cloud Platform ("GCP") businesses. The stock's current price of $179 per share after earnings is largely in line with our updated base case forecast, which considers actual Q2 results and its forward outlook. Our updated base case projections reflect a long-term revenue CAGR of 7.6%. The assumption applied is in line with the historical growth performance at Google's core services and cloud segments, with consideration of incremental AI-drive TAM expansion for GCP. Meanwhile, we expect AI-related efficiency gains for Google's core advertising business to be more evidently reflected in its long-term profitability. This is because the advent of generative AI tools is likely to disrupt and enhance existing advertising technologies, with the integration expected to help Google reinforce future demand instead of expanding its search advertising TAM. Yet incremental efficiency gains and ensuing return on ad spend improvements are likely to help Google command premium pricing from advertisers, which would be a key accretive factor to its profitability. Specifically, AI-enhanced content creation and ad placements are not only expected to drive efficiency gains to advertisers, but also help Google reduce its operating costs as well. This is consistent with results observed from recently introduced generative AI tools for Google's advertising business: With embedded AI enhancements into its core advertising business driving incremental performance and efficiency gains for advertisers, Google continues to be a format of choice. Not only does this reinforce demand, but the AI-driven enhancements in advertising are also favourable to Google's prospects of "commanding premium pricing from advertisers" over the longer-term and help bolster the profit-driving segment's margins. Considering relevant cash flows in a DCF analysis, with the application of a 9.9% WACC and 2% implied perpetual growth rate to determine Google's terminal value at steady-state, the stock presents an estimated intrinsic value of $176 per share. This is in line with the stock's current trading levels at about $179 following its Q2 earnings update, and reflective of our view that impending opportunities from Google's AI strategy has likely already been priced in. But an upside scenario is not yet entirely out of the picture. Google still presents several levers it can pull, in our opinion, to drive incremental growth and unlock further valuation gains from current levels. A key incremental growth driver includes further monetization of YouTube through the greater inclusion of live sports programming. This is in line with recent trends observed at YouTube's streaming peers, with live sports programming gradually migrating from traditional linear TV to streaming platforms. Specifically, YouTube has been a bright spot for Google in recent quarters, with both its advertising and subscription revenue accounting for a growing mix of consolidated sales. YouTube ad revenue grew 13% y/y to almost $9.0 billion during the second quarter, while sales generated from its subscription offerings continue to flourish with a growing number of paid users. Specifically, management continues to highlight subscription growth momentum in YouTube TV and YouTube Music Premium during Q2, which has likely further fuelled its reach into more than 108 million paid subscribers on the platform last disclosed in Q1. Meanwhile, Shorts viewership has also doubled in the past 12 months, underscoring continued improvements to monetization. The continuing momentum has more than offset a tough PY comp due to YouTube TV price increases implemented in May 2023, underscoring strong organic engagement and ad demand on the platform. On the subscription front, YouTube TV has benefitted from momentum, primarily from its live sports programming and exclusive streaming of out-of-market Sunday NFL games. For $72.99 per month (ex-discounts), the YouTube TV base plan allows subscribers to stream more than 100 live channels that span live sports, and scripted and non-scripted content. But by adding on Sports Plus, which includes streaming of more than 13 additional sports networks, YouTube TV garners another $10.99 per month. Meanwhile, the exclusive NFL Sunday Ticket tops another $87.25 per month for four months on existing Base Plan subscriptions - or at a standalone subscription premium of $112.25 per month for four months. This is consistent with live sports programming having historically been the "cornerstone" to linear TV viewership, and emerging observations of relevant content being a key growth driver for streaming platforms. We believe further inclusion of exclusive live sports streaming rights can bolster YouTube's subscription revenue and complement ongoing momentum for the platform's ad monetization efforts. This would be additive to the company's current growth trajectory and unlock incremental valuation gains from the stock's current levels. Specifically, YouTube currently commands the largest share of TV screentime in the U.S. at about 10%, making it a platform of choice for advertisers looking to broaden their respective campaigns' reach. And a deeper foray in live sports streaming through YouTube TV is likely to bolster its streaming market share gains. Specifically, the sporting category has consistently accounted for more than 90% of the 100 most viewed programs on TV each year. This further complements ongoing secular tailwinds in digital advertising, which continues to favour video formats heavily. Specifically, global ad demand for short-form video ad formats are expected to grow by 14% y/y, while ad-supported streaming formats are expected to grow by 18% y/y. This makes YouTube the key beneficiary of the fastest growing advertising formats going forward, with both skippable and non-skippable ad monetization opportunities present across its core formats spanning videos, Shorts, and YouTube TV. And incremental live sports programming is expected to bolster its share grab of emerging secular tailwinds due to YouTube's industry-leading global reach, which is in line with results observed to date from its exclusive host of NFL Sunday Ticket. Additional inclusion of live sports programming is also expected to be additive to the growing revenue mix shift towards YouTube, and improve the segment's margins to better match corporate levels over the longer-term. Meanwhile, ongoing AI investments could also be incrementally additive to YouTube's upside potential, given the nascent technology's assistance to content creation. Specifically, the content creation market attributable to generative AI is expected to grow at a 10-year CAGR of more than 30%, with an estimated 70% of future ad content likely to be overtaken by AI-enabled automation in the longer-term. And Google's continued innovation through AI-enabled content-creating technologies features like Dream Screen, Veo, Google Vids, and Imagen are expected to further bolster YouTube's participation in emerging opportunities. And ensuing efficiency gains realized by content creators are expected to further feed into YouTube's current content feedback loop and become additive to its current TAM - the more efficiency gains brought to content creators will lead to more content uploaded to YouTube, which then encourages engagement and drives more resources for the platform to give back to creators, essentially incentivizing further creation to fuel the feedback loop. However, these endeavours aimed at driving an incremental uplift to Google's overall growth outlook may require additional investments to the currently elevated investment outlay that is being primarily earmarked for AI infrastructure. YouTube is estimated to be paying $2 billion per year for NFL Sunday Ticket under a seven-year deal signed in late 2022. With an estimated two million active subscribers to the sports package every year, YouTube is generating a minimum $698 million in subscription revenue from NFL Sunday Ticket per year under its discounted premium pricing, alongside incremental ad revenue. The extent of YouTube's current returns on the relevant investment remains uncertain, but live sports programming has been fundamental to subscriber acquisition and retention amid intensifying competition, and has played a key role in driving engagement critical for advertisers. This is consistent with soaring prices for exclusive lives sports programming rights on streaming platforms, which is evident in recent deals announced by rivals Amazon Prime Video (AMZN), Apple TV+ (AAPL) and Netflix (NFLX). Specifically, Amazon paid $11 billion for exclusive streaming rights to Thursday Night Football for 10 years; Apple TV+ paid $595 million for exclusive streaming rights to MLB Friday Night Baseball for seven years; and Netflix is estimated to pay about $150 million for exclusive streaming rights to each NFL Christmas Day game between 2024 and 2026. Close to $30 billion of exclusive sports streaming rights will be up for bids this year, representing an opportunity for YouTube to bolster its appeal to prospective subscribers. With YouTube being a margin accretive business to Google Services, alongside Google's deep pockets, the platform exhibits great prospects of deepening its foray in live sports streaming, enabling participation in incremental growth opportunities ahead. In addition to YouTube, Google has also been mulling potential growth investments in Cloud through mergers and acquisition activities. Although recently speculated deals that involve HubSpot (HUBS) and Wiz have fallen through, management remains committed in diversifying Google's investment portfolio, which leaves the door open for further growth synergies ahead. Under the upside scenario, we forecast cash flows based on an 8.7% 10-year CAGR for revenue (vs. 7.6% 10-year CAGR in base case), with YouTube ads and subscriptions, and Google Cloud garnering the largest growth percentage-point increase from the base case. By applying the same valuation assumptions as the base case DCF analysis, upside scenario cash flows yields an estimated intrinsic value for Google at $197 per share. Google's Q2 outperformance has continued to highlight its capability in capturing secular AI tailwinds through its core monetization formats - namely, search ads and GCP. This is in line with expectations that the foundational components to ongoing AI developments - primarily chips and compute capacity - will be key beneficiaries of incoming secular tailwinds. It is also consistent with substantial training capacity and cloud storage required to support burgeoning AI experiments industrywide today - even if they do not materialize into a monetizable product in the future. Meanwhile, Google's core search advertising business' utilization of internally-developed generative AI tools to enable efficiency gains for both itself and its advertisers underscores a significant opportunity for the company to keep monetizing relevant investments. AI integration into its core advertising business makes Google one of the few generative AI innovators in the market that sees a narrowing deficit on relevant investments. A recent report that uses prospective Nvidia (NVDA) data center sales as a proxy for industry spending earmarked towards AI infrastructure shows ensuing returns are currently about $500 billion short of the $600 billion investment outlay. And only hyperscalers like Google, Microsoft, Meta Platforms and Amazon, alongside generative AI innovator OpenAI, represent the concentrated bunch that has been capable of narrowing the harrowing cost-returns gap on relevant investments so far. Yet Google's upsurge this year is, in our opinion, increasingly falling out of balance from an immediately overhanging risk - namely that returns on currently elevated investments continue to rely heavily on the outlook of an AI strategy that remains uncertain. Further upside potential will likely require incremental growth drivers, as we believe the stock's current valuation premium already reflects full realization of the underlying business' existing AI monetization strategy.

Google: A Wafer-Thin Q2 Double Beat Meets Lofty Valuation - Buy, Sell, Or Hold? (GOOG)

Looking for a helping hand in the market? Members of The Quantamental Investor get exclusive ideas and guidance to navigate any climate. Learn More " Introduction Back in April 2024, I downgraded Alphabet Inc. aka Google (NASDAQ:GOOG, NASDAQ:GOOGL) stock to a "Hold" rating at ~$176 per share in light of its Q1 2024 earnings report, citing stretched valuation and unattractive long-term risk/reward: With Alphabet blowing past consensus expectations for Q1, the stock is off to the races. Now, as a long-term shareholder, I'm enjoying these gains. That said, GOOGL stock is now running well ahead of TQI's fair value estimate and the long-term risk/reward from here isn't attractive enough to warrant fresh buys. Considering Alphabet's business strength and valuation realities, I'm moving to the sidelines on this stock. We will continue to own all of our shares, but we won't be buying again until GOOGL experiences a sizable time or price correction. Key Takeaway: I rate Alphabet "Neutral/Hold" at $177 per share. Source: Google Is Alive And Well, But I'm Moving To The Sidelines (Rating Downgrade). While Alphabet scaled new all-time highs of $191.75 per share earlier this month, GOOG stock has retraced back down to the $170s after a -4% dip in the aftermath of its Q2 2024 report. Essentially, Alphabet's stock has gone nowhere for the past three months, underperforming the S&P-500 (SP500, SPY) by roughly 8%. In today's note, we will briefly review Alphabet's Q2 2024 report and re-evaluate its long-term risk/reward using TQI's Valuation Model to make an informed investing decision. Reviewing Alphabet's Q2 2024 Earnings Report For Q2 2024, Alphabet registered a wafer-thin double beat, with revenues coming in at $84.7B (+13.6% y/y, vs. est. $84.3B) and normalized EPS coming in at $1.89 (+31.3% y/y, vs. est. $1.85). While the momentum in Search [$48.51B, +13.7% y/y] and Cloud [$10.35B, +28.8% y/y] businesses remained robust, YouTube Ad revenues of $8.66B [+13% y/y] fell short of consensus expectations of $8.93B. During the earnings call, Alphabet's leadership expressed confidence in YouTube's growth trajectory, citing improving monetization trends for "YouTube Shorts," but this line item is something to keep an eye on for investors. Despite returning to healthy double-digit growth in 2024, Alphabet's management is continuing with its efforts to re-engineer the company's cost base. In Q2 2024, Alphabet's employee count was down to 179.6K [-1.2% y/y and -0.7% q/q]. Consequently, Alphabet's operating margin rose to 32.15% this quarter, up ~300 bps y/y. As of Q2, Google Services boasts an operating margin of 40% and drives the bulk of Alphabet's operating profits! However, Google Cloud is growing rapidly, breaching the $10B per quarter revenue milestone for the first time in Q2 and showing explosive growth in operating profits, which jumped from $0.9B to $1.17B sequentially. For 2024, Alphabet's management expects to deliver operating margin expansion on a y/y basis. That said, Alphabet is investing quite aggressively in its technical infrastructure, and Sundar Pichai & Co. have guided for elevated AI CAPEX spending to continue in upcoming quarters, even risking overbuilding capacity! Ross Sandler Hi, everybody. Just two questions on the AI CapEx. So it looks like from the outside at least, the hyperscaler industry is going from kind of an under bill situation this time last year to better meeting the demand with capacity right now to potentially being overbuilt next year if these CapEx growth rates keep up. So do you think that's a fair characterization? And how are we thinking about the return on invested capital with this AI CapEx cycle. And then related to that, do you think that the AI industry is close to or far away from hitting some kind of wall on foundation model improvement in AI training, based on like lack of availability of new data to train on. Just your thoughts on that would be great. Thank you. Sundar Pichai Thanks Ross. I think great questions. Look, I -- obviously, we are at an early stage of what I view as a very transformative area and in technology when you are going through these transitions, aggressively investing upfront in a defining category, particularly in an area in which in a leveraged way cuts across all our core areas our products, including Search, YouTube and other services, as well as fuels growth in Cloud and supports the innovative long-term Bets and Other Bets is definitely something for us makes sense to lean in. I think the one way I think about it is when we go through a curve like this, the risk of under-investing is dramatically greater than the risk of over-investing for us here, even in scenarios where if it turns out that we are over investing. We clearly -- these are infrastructure, which are widely useful for us. They have long useful lives and we can apply it across, and we can work through that. But I think not investing to be at the frontier, I think definitely has much more significant downside. Having said that, we obsess around every dollar we put in. Our teams are -- work super hard, I'm proud of the efficiency work, be it optimization of hardware, software, model deployment across our fleet. All of that is something we spend a lot of time on, and that's how we think about it. To your second question on whether -- how do the scaling loss hold. Are we hitting on some kind of wall or something? Look, I think we are all pushing very hard, and there is going to be a few efforts, which will scale up on the compute side and push the boundaries of these models. What I would tell is regardless of how that plays out, you still think there is enough optimizations we are all doing, which is driving constant progress in terms of the capabilities of the models. And more importantly, taking them and translating into real use cases across the consumer and enterprise side, I think on that frontier. I think there is still a lot of progress to be had. And so we are pretty focused on that as well. Source: Alphabet Q2 Earnings Transcript (emphasis added). As the ultimate AI company, Alphabet spending money on AI infrastructure is more than justified; however, we are yet to realize an ROI on these ongoing investments, which may or may not arrive in the future. For now, Alphabet's elevated AI infrastructure capex [~$50-55B per year] is hurting its free cash flow generation. In Q2, Alphabet free cash flow slipped to $13.4B, down nearly 40% y/y and 20% q/q! With a net cash balance of $96B, Alphabet's shareholder-friendly stock buyback program and relatively new dividend are likely to remain in place for the foreseeable future. Given Alphabet's ability to pare back its CAPEX investments (in the event of overbuilding capacity), I continue to view Alphabet as a free cash flow machine, despite its wobbly cash generation in recent quarters. Overall, Alphabet's Q2 performance was more or less in line with consensus expectations. However, is Alphabet stock a good investment right now? Alphabet's Fair Value And Expected Return As you may know, I had been bullish on GOOGL stock until its Q1 2024 report was released in April. With Alphabet's valuation catching up to its big tech peers (some of which I'm still bearish on), we re-evaluated GOOGL's long-term risk/reward and learned that it was suboptimal to buy GOOGL in the $170s. With the stock consolidating sideways for three months, let us now re-run GOOGL through TQI's Valuation Model to see if the risk/reward has improved enough to justify the allocation of fresh capital or not. The assumptions for this five-year model are quite straightforward, but I'll walk you through the tricky ones quickly. Alphabet's Q2 FCF margin came in at ~16% [down from ~20-21%]; however, in this model, we will use an optimized FCF margin of 25%, which refers to steady or mature state margins. Currently, Alphabet is re-investing aggressively in AI infrastructure to drive future growth in its business, but when the company reaches terminal growth, I believe Alphabet will generate an FCF margin of 25%-30% [based on the robust margin profile of its Search, YouTube, and Cloud businesses]. To remain conservative with the model, I have opted for a 25% FCF margin assumption. According to Seeking Alpha, Alphabet's consensus revenue estimate for 2029 currently stands at $560B. This estimate implies a five-year CAGR revenue growth rate of ~10.17%. For my model, I have assumed a 10% CAGR revenue growth rate for the next five years, given my belief that AI could unlock massive new revenue opportunities for Alphabet. Generally, I utilize a 15% discount rate in my DCF models. However, I think Alphabet's business resilience and robust cash flow generation warrant a lower discount rate. For this exercise, I assumed a required IRR (discount rate) of 10%, which is what I have used only for Microsoft and Apple in the past. Here's my updated valuation model for Alphabet: As you can see above, our updated fair value estimate for Alphabet is ~$136 per share (or $1.7T market cap), up from $125 per share at our previous assessment. With the stock currently trading around $175, Alphabet is currently overvalued by ~22%. While you may choose to add back Alphabet's huge cash hoard of roughly $100B+ (~$8 per share), the stock is still in overvalued territory. Assuming a base case P/FCF (exit) multiple of ~20x, Alphabet's stock could rise from $175 to $280 at a CAGR rate of 9.88% over the next five years. Yes, Alphabet's expected CAGR return has improved from 7.7% to 9.9% over the past three months and is now significantly higher than treasury yields [~4-5%], so it's a worthwhile investment for anyone looking for a low-volatility tech stock. However, Alphabet's expected CAGR return is more or less in line with the S&P-500's long-term annual return of 8-10%, so why not own a diversified index? Since Alphabet's expected CAGR return is well short of our investment hurdle rate of 15%, I am not a buyer of Alphabet at current levels. Key Takeaway: I continue to rate Alphabet "Neutral/Hold" at $175 per share. At my investing group, we continue to own Alphabet under our Buyback-Dividend strategy; however, last week, we swapped Alphabet with Baidu, Inc. (BIDU) within our GARP strategy due to its far superior long-term risk/reward. Learn more about my investment thesis for the "Google of China" here: Baidu: An Opportunity Of A Lifetime Or A Tragic Mistake. Thanks for reading, and happy investing. Please share your thoughts, concerns, and/or questions in the comments section below. Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. We Are In An Asset Bubble, And TQI Can Help You Navigate It Profitably! Your investing journey is unique, and so are your investment goals and risk tolerance levels. This is precisely why we designed our investing group - "The Quantamental Investor" - to help you build a robust investing operation that can fulfill (and exceed) your long-term financial goals. At TQI, we are pursuing bold, active investing with proactive risk management to navigate this highly uncertain macroeconomic environment. Join our investing community and take control of your financial future today. JOIN THE QUANTAMENTAL INVESTOR "We're in an asset bubble, and I can help you navigate it profitably" I am Ahan Vashi, a seasoned investor with professional background in equity research, private equity, and software engineering. I currently serve as the Chief Financial Engineer at The Quantamental Investor, a community pursuing financial freedom through bold, active investing with proactive risk management. TQI was established in July 2022 with a singular mission to make investing simple, fun, and profitable for all investors. In alignment with this mission, we publish premium equity research reports on Seeking Alpha - research library - performance tracker. However, there's a lot more on offer within our investing group - features include highly-concentrated, risk-optimized model portfolios that meet investor needs across different stages of the investor lifecycle, access to proprietary software tools, and group chats. Learn more In addition to our work on SeekingAlpha, we publish best-in-class investing tidbits and research insights at TQI Tidbits [free newsletter], Twitter, and LinkedIn. Follow for more investing content. Analyst's Disclosure: I/we have a beneficial long position in the shares of GOOGL, BIDU either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Google Q2 Earnings Beat, I'm Staying Long (NASDAQ:GOOG)

In this article, I explain why I remain bullish on Google stock after its second quarter earnings release. Alphabet Inc. (NASDAQ:GOOG), better known as "Google," just released its second quarter earnings. The results ahead what analysts were expecting. Revenue came in at $84.7 billion, up 15%, a beat, while earnings per share ("EPS") came in at $1.89, up 28%, also a beat. Before its second quarter earnings release, Google stock had been getting bid up in the markets. It made a very sharp rise on Monday, when it gained more than 2% at market open. By mid-Day on Tuesday, the stock was up 0.52% from Monday's close. Evidently, investors were feeling optimistic about Google's Q2 earnings release before it came out. Judging by the after-hours ("AH") action, they weren't disappointed. Shortly after Google's earnings release came out, the stock rose 1.4% AH. Commentary on X suggested that investors were impressed with the release. The second quarter release had many valuable operational highlights. The company's Cloud segment again grew by high percentages. Subscription review (largely YouTube premium) increased. The number of employees fell by 1.2%. Overall, these developments provided hope that Google's best days lie ahead of it. When I last covered Google, I rated the stock a "strong buy" because of the improvements the company had been making in generative AI. At the time, many investors still thought that Google was at risk of losing market share to ChatGPT, and that its search monopoly was in danger. Today, such thoughts are not as common as they were when I addressed them. Indeed, the recent earnings release, with its strong growth, confirms what I wrote about Google having a wide economic moat. For this reason and others I'll outline below, I re-iterate my bullish rating on GOOG stock. Earnings Recap Google delivered solid numbers in its second quarter earnings release. The highlight metrics included: Revenue: $84.7B, up 15% (BEAT). Net income: $23.6B, up 28% (BEAT). Diluted earnings per share ("EPS"): 1.89, up 28% (BEAT). Cash from operations: $26.6B, down 7%. Search ad revenue: $48.5B, up 13.8%. YouTube revenue: $8.6B, up 13%. Google Cloud revenue: $10.347B, up 28.8%. 179,000 employees, down 1.2%. These numbers broadly beat analyst estimates, showing that Google remains a strong player in big tech. Particularly encouraging was the high revenue growth observed in the Cloud Computing segment. Not only was the growth high, but the segment was again EBIT profitable. This was a very encouraging result. For a long time, many investors doubted whether Google Cloud could ever become profitable, now the question is whether the segment can achieve a double-digit margin on a full-year basis. Judging by the second quarter earnings release, Google is already part of the way there. Google AI Overviews: Cost or Opportunity? One topic I covered extensively in previous Google articles was the company's application of generative AI. An example of this was in my most recent article, where I mentioned that the company had been receiving good reviews for its then-new AI overviews. If you haven't seen them yet, they are the little generated texts that have been appearing at the top of Google search results for a few months now. These were received much better than Google's Gemini ChatBot, but some analysts thought that they would reduce Search revenue because they crowded out screen real estate traditionally used to show ads. I took the opposite view, arguing that Search overviews could eventually be used to run ads themselves. With Google's earnings release out, we can deliver a preliminary verdict: AI overviews are not killing Google's search revenue. To the contrary, they may be helping it! As we saw in the second quarter earnings release, Google Search revenue maintains its positive growth rate to this day. In fact, search revenue is growing by double digits! And moreover, Google has many other profitable and growing businesses (YouTube, the Cloud, etc.) that provide hope that the future will be even better than today. Valuation Having looked at Google's second quarter earnings release, we can now do a preliminary valuation of Google stock. Since a new earnings release just came out, the relevant multiples need to be updated for the new information. Below, you will find Google's three prior quarters' earnings metrics courtesy of Seeking Alpha Quant, along with the second quarter's numbers straight from the horse's mouth (i.e., the second quarter earnings release). Second quarter First quarter Fourth quarter Third quarter TOTALS Revenue $84.7B $80.5B $86.3B $76.6B $318.1B Diluted EPS $1.89 $1.89 $1.64 $1.55 $6.97 Book value $300.7B N/A N/A N/A $300.7B Operating cash $26.6B $28.8B $18.9B $30.6B $104.9B Free cash flow $13.4B $12.3B $7.8B $16.4B $49.9B Click to enlarge Before going any further, I should give a few notes on the table above: I did not "total" book value because it is a metric that doesn't "accumulate" over time. The second quarter book value is simply the most recent book value figure, incorporating everything that happened leading up to it. The most recent quarter's share count of 12.38 billion can be used to calculate revenue, operating cash flow and free cash flow on a per-share basis. Using the information in point two above, we can create a second table that includes full year per-share amounts as well as the multiples these produce. PER SHARE METRIC MULTIPLE Revenue $26.5024233 Price/sales 6.92766839 Diluted EPS $6.97 P/E 26.34 Book value $24.29 P/book 7.56 Operating cash $8.47 p/cashflow 21.67 Free cash flow $4.03 p/fcf 45.55 Click to enlarge These remain among the lowest multiples you'll see anywhere in big tech today. For comparison, the NASDAQ-100 index (home to many of Google's peers) trades at 32 times earnings. The price/free cash flow multiple might look high but remember that Q4 saw a temporary decline in FCF brought on by a one-time increase in capital expenditure related to Google's new AI investments. Over time, that multiple should smooth out. The Big Risk to Watch Out For On the whole, Google's second quarter earnings were satisfactory. All the headline metrics increased on a year-over-year basis, and beat expectations. It was more than what investors wanted. However, there is still a risk factor that investors ought to keep their eyes on: Legal risk. Google is currently being sued by the Department of Justice (DoJ) for paying other companies like Apple (AAPL) to make Google Search the default search on their platforms. Google spends $20 billion on this every year. The lawsuit could come with financial penalties, and would presumably make Google Search no longer the default search on Apple devices. The potential for a multi-dollar penalty is a serious risk, but it's less clear that the cancellation of the Apple deal would be a real loss. At $20 billion per year, it costs a significant percentage of Google's entire annual profit. The Bottom Line The bottom line on Google is that it's ultra-profitable, it's growing, and its search dominance isn't going anywhere. As the company's second quarter earnings release showed, it's still one of the undisputed Kings of big tech. For my money, it's a strong buy. Financial journalist. Passed CFA Level 1. Seeking value and dividend growth opportunities, and sharing what I find on Seeking Alpha. Follow me on Youtube and Twitter: twitter.com/AJButton2 Analyst's Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Google: Valuation Makes No Sense (NASDAQ:GOOG)

Google also has surprise potential in terms of pursuing new acquisitions in the Cloud/AI/cybersecurity sector after WIZ deal fell through. Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) outpaced earnings estimates for the second fiscal quarter on Tuesday due to continual momentum in the digital advertising business as well as Cloud... which for the first time ever in the history of Google surged past $10B in quarterly revenues. The market has not reacted very positively to the company's second-quarter results, as shares dipped 2% in the after-hours market. Free cash flow strength, Cloud/AI momentum and stock buybacks are the top three reasons why I see a pathway for Google to revalue higher going forward. The Q2 post-earnings dip, should it get more severe in the next several days, would constitute a new engagement opportunity for investors! In my last work on Google in April, I rated shares a strong buy -- On The Cusp Of An Upside Breakout -- after the company reported first fiscal quarter earnings. The reason for my strong buy rating related to Google's solid growth in the advertising business and an accelerating top line. Other reasons for my strong buy rating included Google's $70B stock buyback. Additionally, Google is seeing strong growth in its Cloud business, which posted the highest amount of revenues ever achieved in this segment in Q2. I believe the market underappreciates Google's Q2 achievements, and I am going to be a buyer of the post-earnings dip today. It was another strong quarter for the technology company with Google beating Wall Street's estimates on both the top and the bottom line. Google had $1.89 per-share in (adjusted) earnings on revenues of $84.7B. The EPS estimate beat consensus predictions by $0.04 per-share, while revenues beat by a solid $450M, chiefly on Cloud strength. Overall, Google's second-quarter results were quite good, although the market did react in a more disappointed manner to the company's earnings: shares dropped 2% in the after-hours market. Google generated 14% top-line growth in the second-quarter and reported revenue of $84.7B for Q2'24. The revenue growth rate was twice as high as in the year-earlier period, as the digital advertising market continued to strong growth in the second half of FY 2023 as well as in the first two quarters of FY 2024. Google's total advertising revenues hit $64.6B in Q2 and were mainly driven by Google Search, which generated 14% year-over-year growth. YouTube ad revenues surged 13% year over year to $8.7B, but fell short of the consensus estimate of $8.9B. Especially noteworthy was Google's performance in the Cloud segment in the second-quarter, which generated, for the first time ever, more than $10.0B in Cloud revenues ever. Cloud's $10.3B revenues implied a 29% Y/Y growth rate on demand strength and new AI products that are being rolled out. Google also beat estimates here by $150M. Google Cloud had an 11% market share in the market (as of Statista information, based off of Q1'24 data) which makes Google the third-largest player in the industry, after Amazon Web Services and Azure. Given Google's strong free cash flow -- which is in part used for its generous stock buybacks -- the company has considerable potential to double down on its efforts to grow its Cloud footprint. Google continued to generate a ton of free cash flow in the second-quarter, which is one of the reasons why I continually rated the tech company a strong buy for investors in the past. Google generated $13.5B in free cash flow in the second fiscal quarter on revenues of $84.7B, which calculates to a free cash flow margin of 15.9%. In the last year, Google generated free cash flow of $60.8B and the company is clearly looking for new opportunities to deploy this cash: it tried to buy cybersecurity start-up Wiz for a $23B, which the company just rejected. Wiz is said to pursue an IPO instead. However, Google's strong, recurring free cash flow, generated from its advertising and Cloud business, gives the company considerable options in terms of acquiring growth in ancillary businesses, such as Cloud, cybersecurity and artificial intelligence. (Source: Author) In my opinion, Google shares are widely undervalued based on earnings as the tech company is one of the most profitable companies in the large-cap tech industry... and it is also one of the cheapest. Shares of Google are currently valued at a price-to-earnings ratio of 21.3X compared to an industry group average P/E ratio of 26.8X. The industry group includes other large, free cash flow-profitable tech firms such as Apple (AAPL), Amazon (AMZN), Microsoft (MSFT) and Meta Platforms (META). Amazon is expected to have the strongest long term EPS growth (23% annually), Meta Platforms ranks second (with a projected growth rate of 20%) and Google third (with 18% annual growth). Yet, Google and Meta Platforms are by far the cheapest large-cap tech plays available in the market right now... which is why I am especially optimistic about continual revaluation potential for these two companies. If Google revalues just to the industry group average of large tech companies, 26.9X, shares of the tech company have 26% upside revaluation potential and a fair value in the neighborhood of $230. This fair value is an indicative value only, and I may raise it going forward based off of Google's trajectory in key metrics such as EPS growth, FCF margins and stock buybacks. I believe Google could achieve this fair value target in the next twelve months given that its Q2 earnings showed persistent growth in Cloud and digital advertising and the company has a lot of free cash flow to deploy. Google also has a number of surprise factors that could aid a revaluation to the upside, such as the acquisition of other Cloud/AI/cybersecurity companies or a sizable increase in the stock buyback authorization next year. Google is still overwhelmingly reliant on the digital advertising business, which in the second fiscal quarter accounted for approximately 76% of Google's total revenue mix. A downturn in the digital marketing sector would therefore expose Google to significant growth and valuation risks. Cloud is growing strongly, however, and is offsetting some risks here. What would change my mind about Google is if the company fell behind other companies in the AI race, lost market share in Cloud or saw a decline in its free cash flow margins. Given Google's current strength in the digital advertising market and in Cloud, I believe the 2% post-earnings drop in after-hours trading makes little sense. Google's earnings results were solid, and the tech company beat bottom and top line estimates that I would have expected a more positive reaction. Cloud remains a source of strong growth for Google with a top-line growth rate of 29%. Google's valuation makes no sense to me, however, and I believe the tech company is valued way too cheaply. Google is expected to grow its EPS at 18% annually over the long term, which is inadequately reflected in the company's 21.2X P/E ratio. I see a fair value of at least $230 for Google and consider the company to be among the best deals available for tech investors right now!

Alphabet (GOOGL) Q2 Earnings Beat Estimates, Revenues Rise Y/Y

Alphabet's GOOGL second-quarter 2024 earnings of $1.89 per share beat the Zacks Consensus Estimate by 2.2%. The figure grew 31.3% year over year. Revenues of $84.74 billion increased 14% year over year (15% at constant currency). Net revenues, excluding total traffic acquisition costs ("TAC") (the portion of revenues shared with Google's partners, and the amount paid to distribution partners and others who direct traffic to Google's website), were $71.35 billion, which surpassed the consensus mark by 1.1%. The figure rose 15% from the year-ago quarter. TAC of $13.4 billion rose 6.8% year over year. Solid momentum across Search and YouTube contributed well. The growing cloud segment was a major positive. Accelerating advertisement revenues acted as tailwinds. Alphabet has gained 30.3% year to date, outperforming 25.7% growth of the Zacks Internet-Services industry. However, Alphabet continued to witness sluggishness in Google Network ads, which was concerning. Nevertheless, the company's growing investments in AI, and strength in its Search and cloud businesses are likely to yield massive returns in the days ahead. Growing momentum in Generative AI is another positive. Alphabet reports revenues under Google Services, Google Cloud and Other Bets. Google Services: Revenues from the Google Services business increased 11.5% year over year to $73.93 billion, accounting for 87.2% of the total revenues. The figure beat the Zacks Consensus Estimate of $73.43 billion. Under this business, search revenues from Google-owned sites increased 13.8% year over year to $48.51 billion, surpassing the Zacks Consensus Estimate of $47.5 billion. YouTube's advertising revenues improved 13% year over year to $8.7 billion, while Network advertising revenues decreased 5.2% to $7.44 billion. YouTube ad revenues lagged the Zacks Consensus Estimate of $8.9 billion, while Network ad revenues lagged the consensus mark of $7.9 billion. Total Google advertising revenues rose 11.1% year over year to $64.62 billion and accounted for 76.3% of the total revenues. The figure beat the consensus mark of $64.3 billion. Google subscriptions, platforms and devices revenues, formerly known as Google Other revenues, were $9.3 billion in the second quarter, up 14.4% year over year. The figure beat the consensus mark of $9.2 billion. Google Cloud: Google Cloud revenues rose 28.8% year over year to $10.35 billion, accounting for 12.2% of the quarter's total revenues. The reported metric surpassed the Zacks Consensus Estimate of $10.08 billion. Other Bets: Other Bets' revenues were $365 million, up 28.1% year over year and accounting for 0.4% of the total second-quarter revenues. The figure missed the consensus mark of $415 million. Regional Details EMEA (29.1% of the total revenues): GOOGL generated $24.7 billion in revenues from the region, increasing 11% year over year. APAC (16.3% of the total revenues): The region generated $13.8 billion in revenues, up 9% from the year-ago quarter. Other Americas (5.8% of the total revenues): The region generated $4.94 billion in revenues, up 9% on a year-over-year basis. United States (48.6% of the total revenues): Alphabet generated $41.2 billion in revenues from the region, which increased 17% from the prior-year quarter. Operating Details Costs and operating expenses were $57.32 billion, up 8.6% year over year. As a percentage of revenues, the figure contracted 310 basis points (bps) from the year-ago quarter. The operating margin was 32%, which expanded 300 bps year over year. Segment-wise, Google Services' operating margin of 40.1% expanded 470 bps from the prior-year quarter. Google Cloud reported an operating margin of 11.3%, which expanded 640 bps year over year. Other Bets reported a loss of $1.13 billion compared with a loss of $813 million in the prior-year quarter. Balance Sheet As of Jun 30, 2024, cash, cash equivalents and marketable securities were $100.7 billion, down from $108.1 billion as of Mar 31, 2024. Long-term debt was $13.24 billion at the end of the reported quarter compared with $13.23 billion at the end of the previous quarter. Alphabet generated $26.6 billion of cash from operations in second-quarter 2024 compared with $28.8 billion in first-quarter 2024. GOOGL spent $13.2 billion on capex, netting a free cash flow of $13.45 billion in the reported quarter. Zacks Rank & Stocks to Consider Currently, Alphabet has a Zacks Rank #3 (Hold). Some better-ranked stocks in the broader technology sector are Arista Networks ANET, Badger Meter BMI and Apple AAPL. Arista Networks sports a Zacks Rank #1 (Strong Buy) at present, and Badger Meter and Apple carry a Zacks Rank #2 (Buy) each. You can see the complete list of today's Zacks #1 Rank stocks here. Arista Networks shares have gained 45.3% in the year-to-date period. The long-term earnings growth rate for ANET is projected at 16.07%. Badger Meter shares have gained 30.9% in the year-to-date period. The long-term earnings growth rate for BMI is expected to be 16.73%. Apple shares have gained 16.6% in the year-to-date period. The long-term earnings growth rate for AAPL is anticipated to be 12.48%. Buy 5 Stocks BEFORE Election Day Biden or Trump? Zacks is releasing a FREE Special Report, Profit from the 2024 Presidential Election (no matter who wins). Since 1950, presidential election years have been strong for the market. This report names 5 timely stocks to ride the wave of electoral excitement. They include a medical manufacturer that gained +11,000% in the last 15 years... a rental company absolutely crushing its sector... an energy powerhouse planning to grow its already large dividend by 25%... an aerospace and defense standout that just landed a potentially $80 billion contract... and a giant chipmaker building huge plants in the U.S. Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report Arista Networks, Inc. (ANET) : Free Stock Analysis Report The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Google Earnings: Investing In The Future While Expanding Margins (NASDAQ:GOOG)

Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) delivered a robust set of Q2 results that was met with investor apathy and saw its stock drop a smidge. However, as we look through, I counter that this set of results was rather strong. Particularly when we note that Alphabet is still in investment mode, notably, its heavy investment in Waymo in the coming years of $5 billion, and all the while it delivered significantly expanded profit margins y/y. Given all this, paying 16x next year's operating profits makes terrific sense to me. Alphabet's revenues were driven by strong momentum in key areas such as Search and Cloud. Additionally, Alphabet's AI initiatives are generating substantial revenue, positioning the company well to embrace AI opportunities. Although for some time investors have been concerned about Alphabet's ability to navigate in a ChatGPT and other AI-tools milieu, Alphabet's Q2 2024 results put a nail in that argument. Furthermore, Alphabet's investments in Waymo highlight its commitment to long-term innovation in autonomous driving. The service is now delivering over 50,000 weekly paid public rides, mainly in San Francisco and Phoenix. Alphabet's continued support for Waymo, demonstrated by a new multi-year $5 billion investment, aims to solidify Waymo's position as a leader in autonomous driving technology. That being said, Alphabet faces challenges too. Alphabet reported a decline in network revenues and is facing the impacts of a sequential decline in YouTube subscription growth due to previous price increases. Additionally, Alphabet's failed Wiz acquisition is a reminder that Alphabet must continue to actively address cybersecurity risks, which are intensifying globally. Given this balanced background, let's now discuss its fundamentals. Alphabet's Q2 beat expectations and was up 14% as reported (up 15% in constant currency). And this brings up to the topic du jour. There continues to be a well-known chiasm between the performance of small-cap stocks and mega-cap stocks, see below. As someone who practically solely invests in small caps (asides from Meta (META)), I've often pondered when will small caps return to have their day in the sun. But on the other hand, you can clearly see that Alphabet continues to deliver. We have strong growth, even now, but more importantly than strong growth, you have predictable growth. And that's exactly what investors crave, a steady, strong, predictable, growth rate that gives investors confidence. And, indeed, as a mostly small-cap investor, I know that way too many businesses have their moment in the sun, before fading away. Businesses that are as tried and tested, through the cycle, as Alphabet is, that continue to show that size is no obstacle, are going to continue to get rewarded by investors over time. Even though the market shuns these results, with its shares down premarket, I don't foresee these shares staying lower for too long. After all, its valuation just makes sense to buy. What you see above is that Alphabet was able to deliver strong growth, while expanding its underlying profit margins by 300 basis points. That's just terrific execution! Again, even though investors shun these results, you have to keep in mind that Alphabet is delivering these results while continuing to aggressively invest in their future growth. Case in point, its Other Bets segment increased its losses (or investment?) by 39% y/y to $1.1 billion in the quarter, and despite this tremendous amount of investment, Alphabet still delivered 300 basis points of profit expansion. And on top of all that, Alphabet also has a net cash position that amounts to approximately 5% of its market cap. What's more, given its continuously increasing profits, without aggressive estimates on my part, Alphabet is likely to deliver around $140 billion of operating profits next year. Here are my assumptions. We know that Q4 of each year is typically strongest for advertising companies. This means that the best of this year is yet to come. Also, if we presume that Alphabet's operating profits moderate down to around 15% to 20% next year, versus the 26% y/y increase in operating profits reported this quarter, this would see approximately $140 billion in 2025. Hence, altogether, you have a business that's priced at roughly 16x next year's operating profits, growing in the mid-teens, while still investing for growth. There's a lot to like here. Even now. Paying 16x next year's operating profits for Alphabet makes sense to me because the company demonstrated strong Q2 performance with 14% revenue growth, expanded profit margins, and significant investments in future technologies like AI and Waymo. Despite some challenges, Alphabet's consistent and predictable growth, coupled with its strategic investments, ensures long-term value, making the current valuation highly attractive. Their continued commitment to innovation, even while expanding profit margins by 300 basis points, shows exceptional execution. Considering their strong balance sheet and a net cash position amounting to 5% of its market cap, I believe Alphabet is a smart bet. In other words, the future of Alphabet looks 'alpha-betically' and asymmetrically compelling.

Microsoft Q4 Preview: Google Is Real AI Competition Now (Rating Downgrade) (NASDAQ:MSFT)

The company plans to double capital expenditures by FY2025, with a focus on AI, but competition from Google now poses a real threat. Investment Thesis Since my last coverage of Microsoft Corporation (NASDAQ:MSFT) as a strong buy in April, investors have done well due to CoPilot sales helping power shares higher. However, my concern now lies in the sustainability of this growth, which appears heavily reliant on backend performance to meet Wall Street's ambitious price targets. For example, the consensus EPS estimate for FQ4 2024 is $2.94/share, reflecting a 9.31% year-over-year growth, while revenue is expected to reach $64.37 billion, marking a 14.56% increase from the previous year. These projections indicate a strong short-term outlook, which I think is too optimistic. In the long run, AI will undoubtedly play a crucial role in Microsoft's growth trajectory. The company plans to nearly double their capital expenditures from $32 billion in FY2023 to $63 billion by FY2025, with a significant portion allocated to generative AI and data center capacity. Morgan Stanley predicts that GenAI revenues could increase from $5.3 billion in FY24 to $37.9 billion in FY27, suggesting an aggressive ramp-up in AI-driven revenue streams. Despite this, I am still concerned that Microsoft is prematurely banking on these AI advancements. Looking at the company's valuation, the current forward P/E ratio of 36.93 is substantially higher than the sector median of 24.34. The market is assuming substantial future growth, and I just don't see this as likely now (the market was assuming a winner-take-all outcome for the AI race). The plan was for Microsoft to grab a large AI market share out the gate with their key investment in OpenAI (the makers of ChatGPT). I don't think we saw the massive market share grab they were banking on. True, they did grab some market share. But Alphabet Inc. (GOOG) (GOOGL) is now back with a vengeance. I expect this to get as (or even more competitive) than the cloud wars. Competition often erodes producer surplus (profits). Given these factors, I am downgrading Microsoft shares to a 'hold' until after the earnings report on Wed. If earnings demonstrate stronger-than-expected growth, especially in AI adoption and CoPilot sales, I will reconsider upgrading to a buy or even a strong buy. Why I'm Doing Follow-Up Coverage In my previous coverage of Microsoft back in April of this year, I wrote how I believed shares had about a 10% upside after strong Co-Pilot numbers. Since then, the company has had a fairly solid quarter, with shares increasing by about 10% since then. However, looking forward, I'm just not sure what catalysts there are to power further growth as I think a lot of the AI potential is priced in while the risks are priced out. Microsoft has pushed Copilot to most of their users as an upsell, but the issue is that only so many will convert. With this, the competition from Google highlighted in one of my recent research pieces indicates that the AI market was not a race to adopt a winner-take-all market as many pundits believed a year ago. Microsoft's AI technology is strong, but I do not think it is strong enough out of the gate to push people to search, let alone switch providers. Therefore, this follow-up coverage is meant to demonstrate how market expectations may be inflated in the short run. Expectations Are High Heading into earnings on July 30th, expectations for Microsoft's performance are high. Below is an image of quarterly estimates from Q4 2024 to Q4 2026. As seen in the photo above, consensus EPS estimates for FQ4 2024 are equal to $2.94, marking a 9.31% year-over-year growth, and $3.15 for FQ1 2025, reflecting a 5.48% increase. This trend continues further into the future, with estimates for FQ2 2025 growing 11.40% year over year, reaching $3.26, and $3.43 by FQ4 2025. Over the last three months, there have been 37 upward EPS revisions compared to only 4 downward revisions. Microsoft's revenue estimates follow a similar trend as their EPS, with expectations high as well. Seen below is the quarterly outlook of revenue from Q4 2024 to Q4 2026. Revenue estimates for FQ4 2024 stand at $64.37 billion, growing to $65.31 billion in FQ1 2025, and reaching $70.01 billion by FQ2 2025. This progressive increase is expected to continue, with revenues anticipated to hit $73.08 billion by FQ4 2025 and $84.20 billion by FQ4 2026. In the last three months, there have been 41 upward revisions and only 7 downward. There is a huge bullish bias just as I think the AI momentum is slowing. I think this is misguided. These optimistic EPS and revenue estimates are increasingly dependent on accelerated growth in the later periods. Given these factors, while the current estimates are promising, they are built on multiple assumptions. If these assumptions fail to actually occur, this could significantly hurt Microsoft's future performance, especially given the run-up in the share price YTD and over the last ~18 months What I Am Looking For On The Call As Microsoft approaches their upcoming earnings call, I'll be paying attention to two key areas: CoPilot adoption and competition. One of the primary aspects I will be looking for is evidence that Microsoft is working towards gaining a more competitive edge in the AI market. For a while, Microsoft's partnership with OpenAI granted them this edge. However, this edge is disappearing due to recent developments indicating that competitors like Google are rapidly catching up (again as outlined in my recent coverage on Google) with their new model deployments. Similar to this, I'm also looking to see if the call will cover their current performance compared to competitors like Google and Amazon. In a recent survey focusing on chief information officers, it was found that the majority prefer using Microsoft for their companies' generative AI needs compared to some of their competitors such as Google and Amazon. It would be interesting to see further data on consumer base opinions such as this during the upcoming earnings call. The survey that A16 put out (see my Google research) shows them a close second when you include models being tested before being deployed. In this same train of thought the most critical area will be the focus adoption rates and customer feedback regarding Microsoft's CoPilot product. As I mentioned previously, the initial rollout of CoPilot has been successful and was my reason for a strong buy rating in April. However, I do not think there is much short-term upside left for Microsoft to capitalize on this front as the feedback from some CoPilot users has been poor. Piper Sandler previously anticipated an 18% conversion rate with CoPilot by 2026. Specifically, I will be watching any signs of churn or cancellation of CoPilot subscriptions. With this, the earnings call should provide insights into Microsoft's broader AI strategy, including detailed plans for capital expenditures. For example, as I mentioned previously, Microsoft plans to almost double their Capex from $32 billion in FY2023 to $63 billion by FY2025. As a recent Sequoia report noted, the industry now needs over $600 billion in software layer spend to justify the level of AI capex spend that's taking place. Microsoft (being a big Capex spender) will have to make up a large part of this. Valuation Considering my current stance on the stock is now a hold, I do not feel I can confidently estimate a fair value. There are a few aspects I would like to go over. Despite their robust growth projections, Microsoft's valuation appears stretched compared to their sector medians. For instance, The forward Non-GAAP P/E ratio is currently 36.93, which is significantly higher than the sector median of 24.34, indicating that the market is pricing in substantial future growth. Comparing this to my last report, the forward P/E ratio was 35.33, demonstrating a slight tick upward. Looking at Google, who I think is currently the biggest threat to Microsoft, Google is much more set up for EPS growth than Microsoft. Google's current diluted forward EPS growth is set to be 23.63% year over year, whereas Microsoft's is 11.48%. Despite this, Microsoft's P/E ratio is 36.93, which is roughly 58% higher than Google's (23.30). Not only do I not see as much potential for Microsoft to actually live up to this premium, but this also emphasizes the overvaluation of the stock compared to Google. The market is pricing in Microsoft as the AI leader today, tomorrow, and five years from now. Will this actually be true when we look back? Bull Thesis Although my current stance is a hold, playing devil's advocate, I do think there is still potential for the stock to be valued as a buy if the earnings report is a home run. One of the primary reasons for me to upgrade back to a buy (and for me to admit I was wrong) would be accelerating demand for Microsoft's CoPilot product. Since my last piece, CoPilot has already demonstrated strong initial uptake, contributing significantly to the company's recent financial performance. If this demand continues to grow and adoption rates exceed current expectations, it could provide a substantial boost to Microsoft's bottom line. Some estimates suggest that CoPilot adoption could reach 18% by 2026, which, if surpassed, I think the stock would have more room to run. I mentioned the counterpoint earlier in the article (the boom from the Co-pilot initiative is running out) so I do not see this as a future catalyst to propel accelerated growth. However, at the same time, the company will have to nearly double their capital expenditures from $32 billion in FY2023 to $63 billion by FY2025, primarily to support generative AI and data center capacity. If these investments are used efficiently, I think there is a possibility we will see significant growth in AI-driven revenue streams. For example, Morgan Stanley projected that GenAI revenues could grow from $5.3 billion in FY24 to $37.9 billion in FY27. But there's a real chance this could be misallocated. LLMs went from a developmental software product to a mainstream AI tool in under 2 years (ChatGPT came out in November 2022). We really haven't seen this speed before from development to production of such a revolutionary software tool. Odds are someone will misallocate capital in the AI Wild West. Will it be Microsoft? I'm not sure, but I'm a hold till we have more clarity from the earnings call. Takeaway For now, I'm downgrading my previous rating of Microsoft shares from a strong buy to a hold. Despite the promising growth in AI and cloud services, the current high valuation leaves me concerned. The elevated forward P/E ratio indicates that much of the future growth is already priced in, leaving little room for error. With this, compared to arguably their biggest competition, Google, Microsoft is trading at a much higher premium despite their EPS growth estimates being lower. While there are still many reasons to be optimistic, such as potentially accelerating CoPilot demand from here and extensive investments in AI, these factors must translate into tangible results. I think the upcoming earnings call will give insight into determining whether Microsoft can meet these high expectations and justify their premium valuation. Until then, I place Microsoft as a hold. This account is managed by Noah's Arc Capital Management. Our goal is provide Wall Street level insights to main street investors. Our research focus is mainly on 20th century stocks (old economy) undergoing a 21st century transformation, but occasionally we'll write on companies that help transform 20th century firms as well. We look for innovations in a business model that will cause a stock to change dramatically. Associated with SA contributors Thomas Potter and Elijah Buell. Analyst's Disclosure: I/we have a beneficial long position in the shares of GOOGL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Noah Cox (account author) is the managing partner of Noah's Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Adobe Stock Outlook: A Case For Holding The Position (NASDAQ:ADBE)

Adobe's fundamentals, risks, and valuation suggest it is currently a Hold for investors. Adobe (ADBE) (NEOE:ADBE:CA) has proven an excellent investment over the last decade. Its returns have substantially beaten those of the S&P 500 (SPX). Some investors perceive the company as a massive Artificial Intelligence ("AI") beneficiary and believe AI will help maintain its revenue growth rates. The company reported earnings on June 13, 2024, which showed that its AI products were gaining traction in the market. Although Adobe AI products are still in the early stages, some, such as the AI workflow automation service Firefly, are gaining traction. Chief Executive Officer ("CEO") Shantanu Narayen said on the second quarter 2024 earnings call: We released Firefly services. We've started to see some customer wins in Firefly services. So they're using it for variations, and these are the custom models that we're creating, as well as access to APIs. I would say that's early in terms of the adoption, but the interest as customers say how they can ingest their data into our models as well as custom models, that's really ahead of us, and we expect that to continue to grow in Q3 and Q4. CEO Narayen also discussed how the AI Assistant interfaces in Acrobat and Photoshop have "seen a significant amount of usage." Still, AI also presents risks for the company, and investor worries over slowing revenue growth and lackluster valuation make the company a less-than-ideal candidate for new investment today. I initiate my coverage of Adobe with a Hold. This article will overview Adobe's business and discuss its fundamentals. It will also review the company's risks, valuation, and why the stock is a Hold. Adobe Overview Adobe offers customers content creation, publishing, marketing, and advertising tools. The company can be confusing at first glance for the novice because of the way it has grouped some of its products into reportable revenue segments. The description of some Adobe products may seemingly sit on the borderline of a reporting segment until one understands the company better. The company has three reportable segments: 1. Digital Media Adobe's original core business was in content creation, primarily graphic design, printing, and publishing. Today's Digital Media business is an evolution of the company's original functionalities into the digital age with new services, such as video editing, mobile app development, cloud-based solutions, and other tools to aid creators in designing and delivering content. Two clouds compromise the digital media business: Adobe Creative Cloud and Adobe Document Cloud. The company's 2023 10-K describes Adobe Creative Cloud: Creative Cloud addresses the needs of all content creators, from creative professionals, such as artists, designers, developers, students, and administrators, to knowledge workers, marketers, educators, enthusiasts, communicators, and consumers. Our customers rely on our products for content creation, photo editing, design, video and animation production, mobile application ("app") and gaming development, and more. The company offers Adobe Creative Cloud as a subscription for students and teachers, and small and medium-sized businesses (SMBs). The company provides Adobe Document Cloud as an Acrobat subscription for individuals, SMBs, and enterprises. The 10-K describes Adobe Document Cloud: A unified, cloud-based document services platform that integrates Adobe's pioneering PDF technology with our Acrobat and Acrobat Sign apps to deliver fully digital document workflows across all surfaces. We have the opportunity to continue to accelerate document productivity with Adobe Document Cloud and transform how people view, share, collaborate, and engage with documents. The company is dominant in its Digital Media business and has a high switching cost moat and, to a lesser extent, a network effect moat. The company's cloud products encourage collaboration, and the more people collaborate within the company's cloud products, the more valuable its Digital Media clouds become. Thus, the network effect moat. The high switching cost moat comes from the graphic design, printing, and publishing industries standardizing on several Adobe file formats such as PDF (for documents), PSD (graphics and photo editing), and AI (vector graphics and illustration). According to one website, "PDF is the 3rd most popular file-format on the web (after HTML and XHTML)." This type of dominance makes it challenging for existing Adobe customers to switch to a competitor using a different file format, where file conversion and compatibility issues may arise. The more invested a company or user becomes in learning Adobe's tools, the more reluctant that company or user becomes to switch to a competitor because all the time spent on learning how to use Adobe's sophisticated tools would go to waste. 2. Digital Experience The company expanded from content creation to marketing, mainly by acquiring Magento Commerce and Marketo in 2018. Although Adobe has a solid switching cost moat in its Digital Experience business, it is far less dominant than in its Digital Media business. By establishing this marketing business, Adobe went into direct competition with several heavyweights, including Salesforce (CRM) Commerce Cloud, SAP SE (SAP) Commerce Cloud, Oracle (ORCL) Commerce Cloud, and HubSpot (HUBS). So, it's not number one in Digital Experience like it is in Digital Media. This segment offers AI-powered automation and personalization tools for marketers, advertisers, ad agencies, publishers, and company executives to provide consumers with a personalized experience. It also has tools for business-to-business marketing and content creation and delivery tools. The company provides these tools via Adobe Experience Cloud. The company describes the Experience Cloud in its 10-K: Adobe Experience Cloud is powering digital businesses by helping them provide exceptional personalized experiences to their customers via a comprehensive suite of solutions. Addressing the challenges of customer experience management is a large and growing opportunity and we are in position to help businesses and enterprises invest in solutions that aid their goals to transform how they engage with their customers and constituents digitally. The company will soon offer a generative AI product named Adobe GenStudio, an example of one Adobe product with a description that may confuse some about whether it belongs in Digital Media or Digital Experience. It's a marketing tool that can create AI-generated images while providing content planning, management, and other services. Management decided to include it in the Digital Experience reporting segment because although it has some content creation capabilities, they are for marketing purposes. The company's website states: Adobe GenStudio, coming soon, is an intuitive product that collects the top tools marketers need to deliver on cross-channel campaigns. Built on generative AI, it empowers any team member to quickly find and generate assets, create variations, and optimize experiences based on real-time content performance insights. It's built for small businesses to large enterprises and designed to be used by marketers or agencies. Like the Digital Media Cloud, the Digital Experience Cloud is also a subscription business. 3. Publishing and Advertising This segment contains a mish-mash of the company's legacy products. The company describes the products in this segment in its 10-K, "Our Publishing and Advertising segment contains legacy products and services that address diverse market opportunities including eLearning solutions, technical document publishing, web conferencing, document and forms platform, web app development, high-end printing and our Adobe Advertising offerings." The company could have put some of these legacy products in Digital Media or Digital Experience. However, the company likely put products that don't meaningfully contribute revenue or growth into this segment. For instance, this segment only contributed 0.6% to the company's 2023 full-year revenue, and this segment's revenue declined 7% from 2022. Company Fundamentals The following image shows that Adobe estimates its total addressable market ("TAM") at the end of 2024 as $205 billion. At the end of the first quarter of 2024, the company generated trailing 12-month ("TTM") revenue of $20.43 billion, approximately 10% of its 2024 TAM and 7% of its 2027 TAM of $293 billion. The company has a long runway for growth. Adobe grew second quarter 2024 revenue 10% over the previous year's comparable quarter to $5.31 billion, exceeding analysts' estimates by $15.67 million. Remaining Performing Obligations ("RPO"), the contracted revenue Adobe expects to recognize once it delivers the service to customers, grew 17.3% year-over-year to $17.86 billion. The current RPO, the contracted revenue Adobe expects to realize within the next year, rose 12%. Current RPO growing faster than revenue is generally a positive sign, as it indicates that the company has the potential for faster revenue growth over the next year. Investors will sometimes award a stock a higher valuation when they see a trend of current RPO growing faster than revenue. However, RPO fails to indicate precisely when the company will recognize that revenue. So, investors should not assume that faster current RPO growth will immediately result in more rapid revenue growth. Adobe's second quarter 2024 GAAP (Generally Accepted Accounting Principles) gross margins were 88%, among the highest in the software industry. This is a sign that it has significant pricing power for its cloud-based software tools. Adobe's operating margin is also one of the better ones in the software/cloud industry. Microsoft is one of only a few that exceeds its operating profitability. Management has accomplished this feat while investing heavily in AI. The company's high gross and operating margins, combined with the company generating over 90% of its revenue from a subscription business, may be why the market is willing to award Adobe a premium valuation. The company reported GAAP earnings-per-share ("EPS") of $3.49, beating analysts' estimates by $0.11. The following chart shows that Adobe's Cash flow from operation ("CFO") and CFO to sales both dropped on a TTM basis. The CFO dropped because of a $1 billion termination fee Adobe recorded in the first quarter for the canceled Figma acquisition. Figma, a U.S.-based company, describes what it does on its website: "Figma Design is for people to create, share, and test designs for websites, mobile apps, and other digital products and experiences. It is a popular tool for designers, product managers, writers, and developers and helps anyone involved in the design process contribute, give feedback, and make better decisions, faster." Whether the Figma acquisition would have been good or bad for Adobe is still disputed. On the positive side, the acquisition would have eliminated a major competitor (a possible reason European regulators did not like the deal). On the negative side, when the company announced the terms of the agreement, some felt Adobe overpaid. So, some are glad the deal failed. The termination fee the company needed to pay Figma will hurt Adobe's CFO and free cash flow ("FCF") on a TTM basis for the next two quarters. The following chart shows the drop in FCF. As you read this article's valuation section, remember that Adobe paying Figma a termination fee currently distorts valuations based on FCF. However, in the first quarter of 2025, the negative impact on FCF will be gone, and FCF and FCF margins should move much higher. At that time, investors may view the stock's FCF-based valuations differently. Another thing to note is that Adobe has a relatively high stock-based compensation ("SBC") compared to FCF. According to the reported numbers for the second quarter, the company's SBC makes up 28% of FCF on a TTM basis. Adobe announced a new $25 billion stock buyback program at the end of the March quarter that should minimize shareholder dilution. Still, some investors might find the company's SBC undesirable as it reduces funds it could use to invest in AI, reduce debt, buy back stock, or possibly future dividends. When this article later discusses valuing the stock based on shareholder yield, remember that the company's high level of SBC compared to FCF may negatively impact shareholder yield, potentially lowering the valuation investors award to the company. The following chart shows the company has $8.07 billion in cash and short-term investments against $5.63 billion in long-term debt. Adobe's debt-to-EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) ratio is 0.77, which is excellent and signals that the company is capable of paying its debt obligations. Its debt-to-equity ratio is 0.41, indicating that the company uses more equity than debt to finance its operations. The company's balance sheet is in excellent shape. Risk from AI in content creation For about the last six months, Adobe has been a battleground stock as people debate whether AI will hurt or help the company's content creation business. Some believe that AI will make content creation much more straightforward and make short work of Adobe's switching costs moat. In February 2024, OpenAI demonstrated Sora, a new text-to-video generative AI application, igniting the market's fears over whether AI would quickly disrupt Adobe's video editing business. The stock reacted poorly, with a month-long decline. However, the stock price has since recovered. Adobe responded to the AI concerns in April with a plan to incorporate Sora and other third-party tools into its video editing software Premier Pro. A Seeking Alpha article quoted the following from a company representative: "Adobe is reimagining every step of video creation and production workflow to give creators new power and flexibility to realize their vision," said Ashley Still, senior vice president, Creative Product Group at Adobe in a statement. "By bringing generative AI innovations deep into core Premiere Pro workflows, we are solving real pain points that video editors experience every day, while giving them more space to focus on their craft." Adobe CEO Shantanu Narayen believes that generative AI won't 100% take over areas like video editing because he believes content creation still requires a human creativity aspect. Narayen conducted interviews in 2023 to address AI concerns before Sora even appeared on the scene. He implied in a 2023 CNBC interview that he believes generative AI will be a co-pilot rather than a pilot of content creation. Narayen may be right. However, considering that Microsoft (MSFT) is one of Adobe's most significant competitors and one of the leading AI-focused companies in the world, there is a potential that AI could help it breach Adobe's moats in content creation tools. Other risks In June, The Federal Trade Commission and Department of Justice ("DOJ") filed a civil enforcement action against Adobe for potential violations of the Restore Online Shoppers' Confidence Act (ROSCA). The two government agencies accused the company of making it too hard for customers to cancel annual subscriptions. The announcement of this action on the DOJ website stated, "The lawsuit seeks unspecified amounts of consumer redress and monetary civil penalties from the defendants, as well as a permanent injunction to prohibit them from engaging in future violations." Additionally, the company recently changed its Terms of Service in a way that some users interpreted as giving Adobe royalty-free access to user content to train its AI. The company encountered a considerable backlash, forcing it to clarify its changes in a blog to quell customer discontent. Valuation Adobe looks overvalued based on most traditional valuation methods. Seeking Alpha Quant rates the stock's valuation a D. The stock trades at a price-to-earnings (P/E) ratio of 49.52, above the five-year P/E median but below the seven-year P/E median. Its P/E ratio is also way above the Information Technology sector's PE/ ratio of 31.56. The company's price-to-FCF was 39.49, above the five- and seven-year median. If Adobe traded at its five-year price-to-FCF, the stock price would be $518.61, down 6% from the July 19, 2024 closing stock price. If it traded at its seven-year price-to-FCF, the stock price would be $506.72, down 8%. Let's do a reverse discounted cash flow ("DCF") analysis to determine whether the current stock price is justified. Adobe Reverse DCF The first quarter of FY 2025 reported Free Cash Flow TTM (Trailing 12 months in millions) $6368 Terminal growth rate 2.5% Discount Rate 10% Years 1-10 growth rate 16.6% Current Stock Price (July 19, 2024 closing price) $551.00 Terminal FCF value $30.319 billion Total Present Value of Cash Flows $155.856 billion FCF margin 31.2% Click to enlarge Since analysts expect Adobe's revenue to grow at a CAGR of 11% over the next ten years, the assumptions I used in the above DCF would not justify a stock price of $551 at a 31.2% FCF margin. Still, the company will likely average a higher FCF margin moving forward. In 2021, Adobe had reached an FCF margin of 43.67%. Although its FCF margin dropped substantially over the last year due to the Figma termination payment, analysts expect an FCF margin of 40% in 2025 and 2026. The following table assumes that the company maintains revenue at a CAGR of 11% over the next ten years. The left column is the FCF margin the company can average over the next ten years, and the right column shows the expected stock price. The following estimated stock prices are well below Adobe's July 19 closing stock price of $551.00, suggesting the market overvalues the stock at a forecasted revenue growth rate of 11% over the next ten years. FCF margin Estimated Stock price 36% $422.57 37% $434.29 38% $446.01 39% $457.74 40% $469.51 Click to enlarge Alternatively, assuming the FCF margin is at an average of 36% over the next ten years, and the company could maintain revenue growth at 20% over the next ten years, the estimated intrinsic value would be $817.29, up 48% over the July 19 closing stock price. Several valuation methods suggest that the market undervalues Adobe. The company's price-to-sales ratio is 12.31, below its five- and seven-year median. If the company sold at its seven-year median, the stock price would be $622.58, up 13% over its closing price on July 19, 2024. The company's Enterprise Value to Sales (EV/S) is 11.99, compared to its average five-year EV/S ratio of 14.13. If the stock traded at its five-year average EV/S, its price would be $632.88. The assumptions I used with EV/S and P/S valuations are slightly above analysts' consensus one-year price target, as seen in the image below. Sometimes, when I get too many conflicting signals about a stock's potential overvaluation or undervaluation, I will look at shareholder yield, which is cash dividends, stock repurchases, and debt reduction divided by market capitalization. Generally, when shareholder yield is low, the market overvalues the stock. When shareholder yield is high, the market overvalues a stock. According to those rules, the best time to buy Adobe over the last five years was from the middle of 2019 to the beginning of 2022 and at the end of 2023. At the current shareholder yield, it sits right in the middle of its shareholder's yield high of nearly 4.0% and its low of around 1.5% over the last year and a half, suggesting the market is fairly valuing the stock at its closing stock price on July 19 of $551. Initiating Adobe with a Hold If you have bought Adobe at shareholder yields below 2%, it may still be worthwhile to hold. However, investors who have yet to buy the company would be better off avoiding the stock at a shareholder yield of 2.88% and higher. I might have believed differently if the company's revenue growth estimates were 20% or higher, but revenue growth has already descended to 11%. Additionally, the proliferation of AI could potentially increase Adobe's competitive threats and further decrease revenue growth to single digits. Adobe is a Hold. I have been a Merchant Seaman that has traveled the world for over 30 years. Within the last 15 years, I developed a very intense interest in investing. I learned a lot of what I know about investing from The Motley Fool. Also because I have a engineering background, I often tend to gravitate to Tech stocks Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

AMD: Valuation Concerns Persist Despite Recent Dip

My valuation analysis suggests that the stock is 14% overvalued, even with aggressive growth assumptions. My previous bearish thesis about AMD (NASDAQ:AMD) aged decently as the stock substantially lagged behind the broader U.S. market since April with a negative share price change. Today, I want to explain why I remain quite bearish about AMD, especially in light of the upcoming Q2 earnings release. Valuation still looks like a problem as AMD's valuation ratios are sky-high and my optimistic DCF model suggests that the stock is 14% undervalued. The fact that AMD is likely overvalued is also backed by insiders, who were only selling the stock over the last 12 months with no buys. AMD's financial performance is poised to continue substantially lagging behind Nvidia (NVDA) in the next few quarters, which will mean that the company's major rival will likely be able to ramp its innovation spending much faster. All in all, I reiterate my "Sell" rating for AMD. The company released its latest quarterly earnings on April 30, surpassing consensus and adjusted EPS estimates. Revenue's growth pace in Q1 was behind the U.S. inflation with a very modest 2.24% YoY increase. The adjusted EPS expanded from $0.60 to $0.62 YoY. While the adjusted EPS expansion is generally good, the Q1 2024 bottom line was far lower compared to Q1 2022 level, which was at $1.13. Nevertheless, AMD's free cash flow [FCF] is positive. The levered FCF generated during Q1 2024 was $884 million, which contributed to the company's robust balance sheet. The upcoming Q2 earnings release is scheduled for July 30. Wall Street analysts forecast Q2 revenue to be $5.72 billion, which will be around 6.7% YoY growth. The adjusted EPS is projected to expand from $0.58 to $0.68. Wall Street's sentiment around the upcoming earnings release appears to be mostly negative with notably more EPS downgrades than upgrades over the last 90 days. AMD's modest revenue growth despite massive AI tailwinds is a warning sign, in my opinion. According to quarterly consensus estimates, AMD's revenue is expected to notably accelerate by Q4 2024. However, figures do not tell much without context. Using Nvidia's expected revenue growth for the next three quarters looks like a sound benchmark. AMD and NVDA have different fiscal year ends, so to make it simple I will name the upcoming three quarters just like Q2, Q3, and Q4. As shown above, AMD's projected revenue growth is nowhere near NVDA's. Moreover, let us not forget that Nvidia's revenue is already extremely high compared to historical levels as its TTM $80 billion revenue is around three times higher compared to the 2022 revenue [out of 12 months of FY 2023, 11 were in calendar year 2022]. At the same time, AMD's TTM revenue is still lower compared to FY 2022 revenue. That said, it is apparent that the gap between NVDA and AMD in the AI market positioning will continue to expand further. Moreover, Wall Street analysts are much more optimistic around NVDA's upcoming quarter's earnings release with 38 EPS upgrades over the last 90 days and almost no downgrades [see below]. I am highly confident that the gap between NVDA and AMD will continue to widen because the GPU leader is already dream away in terms of the R&D spending. With NVDA's key P&L metrics expected to significantly outpace AMD, the same will likely happen to R&D. The stock rallied by 30% over the last 12 months, notably outperforming the broader U.S. market. From the YTD perspective, AMD is well behind the S&P 500 with a modest 3% share price increase. AMD has a low "D-" Seeking Alpha Quant valuation grade because most of its multiples are high compared to both sector median and historical averages. Another factor that underscores AMD's overvaluation is the comparison of its valuation ratios to Nvidia's. As we see, most of the ratios are comparable and some of AMD's multiples are even higher compared to NVDA. This looks unfair to me because AMD's growth across key P&L metrics is not even close to NVDA. Looking only at valuation ratios is unlikely to be sufficient. Therefore, I must simulate the DCF model. To figure out the discount rate for AMD, I ignore the cost of debt for AMD because its total debt is quite insignificant compared to the company's market cap. Therefore, the discount rate will be equal to AMD's cost of equity, which is figured out in the below table using the CAPM approach. All variables are easily available on the Internet. Revenue consensus estimates are available for only five upcoming years, so I have to build my own revenue growth forecast for the years beyond FY 2028. It is impossible to figure out from the company's 10-K report the share of GPU's and CPU's it sells. The company disaggregates revenue by end markets, but not by product types. Given AMD's quite diversified revenue mix, I think that a fifty-fifty mix would be fair for my estimations. It is crucial to understand shares of CPUs and GPUs in the company's revenue mix because these products have very different growth prospects for the next decade. For example, GPUs are projected to compound with a 26.4% CAGR over the long term. On the other hand, CPUs are expected to demonstrate much more modest growth with a 10.5% CAGR. Assuming that GPUs and CPUs are evenly split in the company's revenue mix, an 18.5% CAGR projection for AMD's revenue over the long run looks reasonable. I apply this revenue growth rate for the years beyond FY 2028. Considering the mix of consensus projection for 2024-2028 and my assumptions regarding years beyond 2028, the next decade's revenue CAGR is 18%. I use a TTM 4.1% FCF ex-SBC margin for the base year and forecast a 1.8 percentage point yearly expansion, which correlates with the projected revenue growth. According to my DCF valuation, the business's fair value is $210 billion. This is around 14% lower than the current market cap. That said, the stock looks quite overvalued in my opinion, especially considering optimistic revenue and profitability growth assumptions. The factor that I consider to be robust evidence that the stock is overvalued is the fact that insiders were only selling over the last 12 months. Lisa Su, the CEO, is likely to consider the stock overvalued as she has been selling aggressively in recent months with stock worth around $90 million sold over the last six months. AMD has a robust historical stock performance in July and August, which we can see from the seasonality analysis below. This means that the stock might rally in the last few days of July and in August. However, it is also crucial to mention that September is the stock's by far historically weakest month over the last decade. The market's reaction on earnings release is difficult to predict. AMD might deliver above the consensus performance, but the market might consider even a slight downgrade in Q3 guidance as a disaster, and this might potentially lead to a sell-off. However, it also works the other way round as well. AMD might deliver relatively weak Q2 performance, but Lisa Su might announce a new jaw-dropping chip release which will be a potential threat to NVDA's offerings. That said, there is a risk that earnings release can potentially be a positive catalyst for the stock price, even if financial performance will be nothing special. AMD is one of the best-performing stocks of the past decade with a 3,900% total return. A lot of people who invested in AMD ten years ago became much wealthier thanks to this investment. Therefore, it is highly likely that the stock has an impressive base of fans who are ready to tolerate volatility and will be willing to buy any dip. This might support the stock price even further, despite the current overvaluation. Should this happen, my thesis is unlikely to age well. It appears that all notable semiconductor names are likely to be moving in line with NVDA. For example, in "Valuation" we saw that AMD's revenue and profitability growth is not even close to NVIDIA's. However, AMD's stock price increased by more than two times since January 2023, and I believe that the notable portion of AMD's rally related to the big rally in NVDA. That said, a new rally in NVDA might boost AMD's share price higher, even if the company's fundamentals will not improve accordingly. To conclude, AMD still looks like a "Sell". The stock is still notably overvalued, which is a red flag, especially considering the weak Wall Street's sentiment around the upcoming earnings release. The red flag which supports my opinion about the stock overvaluation is the fact that insiders were only selling the stock over the last 12 months. The gap between NVDA and AMD in the AI race is expected to widen further, which will highly likely undermine the company's long-term growth potential.