Google: $75 billion crazy investment in AI, big brother goes crazier than Meta

After the market closed on February 4th Eastern Time, Google's parent company Alphabet$Alphabet(GOOGL.US) released its Q4 2024 financial report. The stock fell 8 points after hours, primarily due to disappointing cloud business performance, which compounded the issue as the company plans to significantly increase capital expenditures this year.

From a medium to long-term perspective, there is still debate over whether AI will clearly disrupt Google's$Alphabet - C(GOOG.US) search entry, and with ongoing antitrust regulatory concerns, the strong performance of the cloud business and stable search advertising in the first two quarters allowed the market to temporarily set aside long-term worries and focus on enjoying the present.

Therefore, the slower-than-expected growth of the cloud business and the higher-than-expected Capex$Direxion Daily GOOGL Bull 2X Shares(GGLL.US) will undoubtedly disappoint some investors and cool down the recent enthusiasm for Google's rebound.

Key information:

1. Cloud business growth slows due to AI "supply shortage": The cloud business is the main area of concern in this financial report, which is why it is highlighted first. The cloud business, which has performed well this year, saw a year-on-year growth of 30% in Q4, while the market expected over 32%. The cloud business's performance was a key factor in alleviating market concerns about AI disrupting search, so this underperformance will disappoint some investors.

Originally, in Q3, Google's backlog of contracts grew by 34% year-on-year, further accelerating compared to Q2. Based on normal consumption trends, Q4 should not have been too bad. During the conference call, management mentioned that the slowdown in growth was due to high base effects and also a "supply shortage" leading to insufficient growth. This is also the reason the company announced plans to increase capital expenditures by $75 billion in 2025 to expand capacity.

2. Search fundamentals remain stable: Search continued to grow steadily at 12.5%, with market feedback indicating relatively sufficient expectations. Specifically, Q4 is the peak season for e-commerce, so retail e-commerce demand remains significant, followed by interest-sensitive industries such as finance, automotive, and tourism, which are relatively stable. Additionally, advertising related to the U.S. elections is expected to contribute positively 3. YouTube advertising shows slight recovery: In the fourth quarter, YouTube managed to withstand high base pressure again, with year-on-year growth rate continuing to recover to 13.8%. This was mainly driven by the U.S. elections, brand advertising during the shopping season, increased user engagement with Shorts, and new advertising budgets driven by AI (AI improves precise recommendations and video generation models help advertisers quickly generate ad creatives).

4. Other revenue performance fell short of expectations, mainly due to fluctuations in Pixel hardware sales cycles: In the fourth quarter, the growth rate of other revenues rapidly declined to 8%, primarily due to the early release of the Pixel 9 series phones, including Gemini Nano, in the third quarter, which caused fluctuations in year-on-year growth. However, software service revenues outside of hardware, such as YouTube TV, Music Premium, and Google One, grew normally.

5. Profitability improvement relies on operational efficiency: In the fourth quarter, the operating profit margin remained at 32%, an increase of nearly 5 percentage points year-on-year. During the gradual confirmation of high Capex investments, this was mainly due to the company's control over expenses, especially with sales and management expenses declining year-on-year, while R&D expenses only slightly increased by 5%.

In the last quarterly conference call, the company mentioned that it is using AI to replace some IT personnel, such as basic coding functions. In the fourth quarter, the number of employees increased by 2,054 compared to the previous quarter, but overall, it remains manageable. By business segment, the profit margin for cloud services further increased to 17.5%, benefiting not only from the aforementioned cost control but also from several newly signed high-margin large contracts. The market expects that in the next two years, the operating profit margin for cloud services can steadily increase to 20%.

6. Stable shareholder returns realized

At the beginning of the year, Google announced an additional buyback quota of $70 billion and a first-time dividend package. In the fourth quarter, it actually repurchased $15 billion and distributed $2.4 billion in dividends. Although the market value has significantly increased in the fourth quarter, the management's buyback effort remains consistent with the previous quarter.

In the past 12 months, total shareholder returns have reached nearly $80 billion (buybacks + dividends). Dolphin estimates that based on this buyback and dividend pace, the expected annualized return from buybacks and dividends is 3%.

7. Key indicators compared to expectations

Dolphin's Viewpoint

Objectively speaking, the fourth-quarter performance is not bad; advertising remains strong, and even if the growth rate of cloud services slows down beyond expectations, the actual discrepancy is not significant. Moreover, during the conference call, management strongly asserted that AI cloud demand is robust, and the slowdown in growth is entirely due to "insufficient supply." Therefore, we believe that what truly shocked the market, especially Google investors, should be the $75 billion super high Capex investment.

This represents an increase of over 40% compared to the $52.5 billion in 2024, especially considering that it has already grown by 63% in 2024. This Capex includes infrastructure such as servers and data centers to support the development of advertising, cloud services, and DeepMind's business. On the other hand, it includes investment in the research and development of self-developed ASIC chip TPU.

This will undoubtedly scare some value investors who prefer Google's stable profit growth, but aggressive growth investors may not be too alarmed. Therefore, Google seems to be in a situation similar to Meta's in the past two years. If the advertising business continues to remain robust and can prove that AI investments bring more positive momentum to overall advertising (rather than just affecting traffic migration from search entry), then high investments may allow funds to turn a blind eye; however, if the worst-case scenario is "not worth the cost," then emotional valuation adjustments could be seen for Google.

However, Dolphin tends to lean towards the first scenario. Based on past management experience, Google's management is not overly aggressive, especially compared to Zuckerberg's impulsive nature that can lead to erratic behavior; Google's management is more prudent.

On the other hand, compared to Meta, Google's advertising scale is larger, and its ecosystem traffic scale is not inferior to Meta's. After all, there are also cloud services, the gradually emerging TPU chip, and cutting-edge technology research like DeepMind that require substantial infrastructure support, so the higher investment than Meta's $65 billion is actually understandable.

More importantly, AI for Google is not merely a nice-to-have but requires significant investment to defend its position, necessitating full commitment.

Currently, Google rebounded to over 23x before the earnings report (close to the valuation repair range judged by Dolphin 君 last quarter), mainly due to the release of powerful Gemini 2.0, quantum chip Willow, progress with Waymo, the hype surrounding Robotaxi, and better-than-expected feedback on AI search advertising, which led to a rapid increase. Therefore, this sell-off was just an opportunity to digest some of the overly high "catch-up enthusiasm" in the short term.

At least in the short to medium term, the impact of AI on Google's search entry, which also possesses leading AI technology capabilities, cannot be reflected. There may be some user traffic migration, but considering the scenarios and the underlying business ecosystem, Google is currently stable and secure. The medium to long-term trend is hard to be optimistic about, but it is also difficult to make accurate judgments; it requires a watch-and-see approach, and in the short term, it should still return to fluctuations around the valuation center.

The following is a detailed interpretation of the earnings report.

Basic Introduction to Google

Google's parent company, Alphabet, has a wide range of businesses, and its earnings report structure has changed multiple times. Friends who are not familiar with Alphabet can first take a look at its business structure.

A brief explanation of Google's fundamental long logic:

a. Advertising business, as the main source of revenue, contributes significantly to the company's profits. There is a medium to long-term risk of search advertising being eroded by information flow advertising, which is being supplemented by the high-growth streaming platform YouTube.

b. Cloud business is the company's second growth curve, which has turned profitable. In the past year, there has been strong momentum in recent contracts. As advertising continues to be dragged down by weak consumer spending, the development of the cloud business is becoming increasingly important to support the company's performance and valuation imagination.

II. Revenue: Advertising base is solid, subscriptions and cloud services exceed expectations

In the fourth quarter, Google's overall revenue was $96.5 billion, a year-on-year increase of 12%, in line with expectations.

Among them, the core pillar, the advertising business, accounted for 75%, with a year-on-year growth of 10.6%, maintaining steady growth despite a high base. This is due to the robust U.S. economy in the fourth quarter, with strong advertising demand driven by the holiday season and political advertising during the election period. Prior to the earnings report, several advertising research feedbacks indicated that Google's search performance was strong and exceeded expectations.

Beyond advertising, Google Cloud services, driven by AI, still grew at a high rate of 30%, but showed a noticeable slowdown compared to the previous quarter, slightly below market expectations.

Additionally, other revenues such as YouTube subscriptions, Google Play, and Pixel series hardware fell short of expectations, mainly due to Pixel phone sales being brought forward to Q3, which disrupted the year-on-year growth rate for Q4.

Specifically:

(1) Advertising: Search remains strong, YouTube shows slight recovery

In the fourth quarter, advertising revenue was $72.5 billion, with an overall growth of 10.4%, maintaining growth levels despite a high base. Due to the resilience of macro data and positive feedback from advertising experts, overall institutional expectations are relatively sufficient. In detail, search is strong, YouTube is recovering slightly, but affiliate advertising is below expectations.

a. Search advertising In the fourth quarter, Google's search revenue reached $54 billion, a year-on-year increase of 12.5%. The growth rate has remained strong this year, and besides macro stability, the short-term effects of AI + search have already become apparent:

(1) In May, Google launched the AI search feature SGE integrated with the Gemini large model (later renamed AI Overview), which timely addressed the demand for AI functionalities. Subsequently, at least in the context of general search, the motivation for users to migrate elsewhere will weaken somewhat in the short term.

From the advertisers' perspective, given that traffic is not advantageous and the corresponding advertising ecosystem has not yet been established, the likelihood of advertisers' budgets significantly migrating quickly is low. However, this is primarily based on a short to medium-term view, and there are still concerns in the medium to long term.

(2) AI provides marketing tools for advertisers, improving conversion rates. Due to Google's technological leadership, it can effectively provide advertising conversion rates and marketing costs for advertisers through AI tools like Pmax, based on a deep understanding of the advertising industry.

(3) Besides internal factors, the fourth quarter is a peak shopping season, and the overall industry (mainly retail) has shown resilient growth, while interest rate-sensitive financial industry advertisers have also increased their spending. Additionally, there has been an increase in political advertising related to the U.S. elections, and these advertisers are often significant clients for search ads, thus driving short-term growth in search advertising.

b. YouTube Advertising

YouTube seems to be gradually emerging from the shadow of internal erosion by Shorts, achieving advertising revenue of $10.5 billion in the fourth quarter, a year-on-year increase of 13.8%, slightly exceeding expectations. According to Nielsen reports, YouTube's viewership share on connected TVs has been steadily rising, which is a key reason for YouTube's resurgence.

c. Affiliate Advertising

Affiliate advertising revenue declined by 4% year-on-year in the fourth quarter, falling short of market expectations. The market initially anticipated that after the company proposed to temporarily halt the abandonment of third-party cookies, affiliate advertising could gradually return to stability.

However, in the previous quarter's earnings report, Dolphin also mentioned the inevitable medium to long-term pressure on affiliate advertising:

Google launched AI search functions to respond to the competition from new AI forces against traditional search scenarios, and of course, it is also aimed at improving user experience with new technologies. However, for platforms that rely on Google for advertising distribution, AI search Q&A provides a filtered summary of optimal answers, eliminating the process for users to click through links, thus significantly reducing the effective user clicks and behavioral data obtained by distributors, which in turn affects the advertising effectiveness for distributors.

However, for Google itself, the impact of affiliate advertising on profits is far less than on revenue. The affiliate advertising business, which accounts for 8% of revenue, has to share most of its income with external advertising distribution platforms, so its profit margin is not high. It is expected to be at a high single-digit level; for example, in 2024, the operating profit contribution of affiliate advertising to the overall company is estimated to be 2%, theoretically making the financial impact relatively controllable (2) Cloud: Growth slightly exceeds expectations but may be due to "supply shortages"

In the fourth quarter, the cloud services division achieved a total revenue of $12 billion, with a year-on-year growth rate of 30%. This represents a certain slowdown compared to the previous quarter, and the extent of the slowdown slightly exceeded market expectations, which is one of the core factors for the market's negative feedback on the financial report.

The unexpected slowdown in cloud business has raised concerns in the market about whether AI demand remains as strong as before. During the conference call, management emphasized that the slowdown in cloud business is influenced by "supply shortages," which is also the reason the company decided to significantly increase capital expenditures in 2025 (up 40% compared to 2024).

The cloud business is B2B, so it may be related to the long-term competitiveness of its products, but short-term changes are more easily affected by the scale of new contracts signed in the current or previous period.

Therefore, Dolphin generally uses Google's Revenue Backlog metric to assess short-term trends. Most of this metric comes from the cloud business, so its trend can also be seen as a change in the volume of unfulfilled contracts in the cloud business.

Based on the scale of contracts, the actual prosperity of the cloud business in the fourth quarter should still be good. As of the third quarter (data for the fourth quarter needs to be found in the complete annual report submitted to the SEC, although the data is lagging, the overall trend can still be observed), Google's cloud backlog reached $86.8 billion, a year-on-year increase of 34%, and further accelerated on a quarter-on-quarter basis. Dolphin estimates a net increase in contracts of $19.4 billion, which is also higher than the $16.7 billion in the second quarter, but the increase is not as strong as the pull from the second quarter to the first quarter.

Dolphin will update the contract backlog situation for the fourth quarter in the Longbridge app's stock panorama—performance composition module after the complete annual report is disclosed, so interested parties can pay attention.

(3) Other Businesses: Rapid slowdown in growth, mainly due to the misalignment of Pixel sales cycles

In the fourth quarter, other revenues achieved $11.6 billion, with a year-on-year growth of 8%, showing a significant slowdown compared to the previous quarter. This revenue mainly comes from YouTube subscriptions (TV, music, etc.), Google Play, Google One, and hardware (Pixel phones and smart home devices like Nest).

The slowdown in growth is mainly due to the early release of the Pixel 9 phone in the third quarter, which has traditionally been released in the fourth quarter, causing a misalignment in the short-term sales cycle and resulting in fluctuations in growth (abnormally high in Q3, abnormally low in Q4). Software services outside of hardware, such as YouTube TV, Music Premium, and Google One, continued to grow normally

III. Improving efficiency and stabilizing profit growth rhythm, but ultra-high Capex is on the way

In the fourth quarter, the operating profit of the core business was 31 billion, a year-on-year increase of 31%, with a profit margin maintained at 32%, stable quarter-on-quarter, and steadily increased by 5 percentage points year-on-year, slightly exceeding expectations.

Overall, the ability to maintain a high operating profit margin is mainly due to efficiency improvements, specifically the control of basic operating expenses. In particular, sales expenses and management expenses have decreased year-on-year, while R&D expenses have only slightly increased by 5%. However, the gross profit margin has declined due to increased investments in YouTube and Google One content, misalignment in hardware cost sales cycles, and increased costs for some AI servers.

In the last quarter's conference call, the company mentioned that it is using AI to replace some IT personnel, such as basic coding functions. In the fourth quarter, the number of employees increased by 2,054 compared to the previous quarter, but overall it remains controllable.

By business segment, the profit margin of the cloud business further increased to 17.5%. In addition to the aforementioned cost control, it also benefited from several newly signed high-margin large contracts. Market expectations are that in the next two years, the operating profit margin of the cloud business can steadily increase to 20%.

Regarding aggressive capital investments, the market mainly discussed Meta before the financial report, with little expectation for Google, which has never provided quantitative guidance. However, this time not only did the fourth quarter Capex continue to rise and exceed expectations, but the management also unprecedentedly provided a clear and significantly increased quantitative guidance for 2025—an expected annual Capex investment of $75 billion, a year-on-year increase of over 40% compared to 2024, exceeding the market expectation of around $60-65 billion.