Google: The AI wolf hasn’t arrived, but the king of advertising remains firmly in command

After the market closed on July 24th, Eastern Time, $Alphabet(GOOGL.US) $Alphabet - C(GOOG.US) released its Q2 2025 financial report. Due to concerns over search market share and antitrust litigation, Google's valuation has been consistently suppressed, significantly lower than other Mag 7 companies.

In reality, while future erosion risks may still exist, Google has been the first to taste the benefits of AI, leading management to confidently raise the full-year Capex guidance, reflecting their determination for transformation.

Key insights are as follows:

1. Overblown concerns about search?: The search business has been the main point of divergence causing expectation discrepancies over the past two years, with each concern seemingly being a false alarm. The second quarter was particularly chaotic—third-party research from SimilarWeb and others indicated that Google's search share had accelerated its decline to below 90%. An Apple executive's comment that "due to AI platform diversion, Safari's search volume has declined for the first time" directly spooked the market, forcing Google to urgently refute the claim.

In reality, it was another "false alarm," with a year-over-year growth rate of 11.7% in the second quarter. Even excluding a 1% currency tailwind, there was a slight acceleration quarter-over-quarter. The driving forces included the integration of the Gemini large model in application scenarios (such as Google Shopping), the penetration of AI advertising tools among clients (such as Pmax), and the increase in user time spent in AI scenarios (such as AI Overview), with more advertisers recognizing the improvement in ROAS brought by AI. Despite the impact of tariffs in April, although cross-border e-commerce advertising from Temu and Shein was withdrawn, other advertisers quickly filled the ad slots.

However, the market had already raised expectations based on advertiser surveys before the earnings report, so from a truly unexpected perspective, it was a pleasant surprise rather than a stunning one.

2. YouTube's time-driven growth: Thanks to the popularity of CTV and Shorts among users, time spent and browsing share increased, allowing YouTube to maintain its growth momentum, with a 13% growth rate in the second quarter, offsetting some of the volatility and growth pressure faced by brand advertising in a turbulent environment.

3. Google Cloud's strong momentum: The cloud business continued to achieve high growth through AI, with management repeatedly emphasizing over the past year that the cloud business was in high demand, with growth resistance mainly due to the release of supply capacity. The cloud business grew by 31.5% in the second quarter, accelerating from the previous quarter, possibly due to the server data center capacity catching up, alleviating supply issues.

4. Strong growth in other income: The growth rate accelerated to 20% in the second quarter, with the main growth drivers likely being subscription revenue from YouTube CTV and Google One.

5. Is affiliate advertising a casualty of AI transformation?: Affiliate advertising continued to be under pressure in the second quarter, declining by 1.2% year-over-year. With AI Overview further increasing the penetration of search results, websites that partner with Google for ad publishing are somewhat affected by a decline in click-through rates, so the growth pressure on affiliate advertising may persist in the long term.

6. Excluding legal fees, profitability is actually good: The operating profit margin declined quarter-over-quarter in the second quarter, mainly due to $1.4 billion in legal fees (2022 data privacy lawsuit settlement fees). Excluding this, the profit margin remained flat quarter-over-quarter, exceeding market expectations.

In terms of other expenses, sales expenses remained stable, while R&D expenses continued to accelerate, with a net increase of 1,384 employees in the second quarter. Considering that a new employee optimization plan (voluntary departure program for the traditional advertising department) was also introduced in the second quarter, the new employees are likely mainly focused on AI research and development. By business segment, the improvement in profit margins mainly benefited from the profitability improvement in the cloud business.

7. Buyback momentum slows in the short term: The second quarter saw $13.6 billion in buybacks and $2.5 billion in dividends. The combined shareholder return slowed compared to the first quarter. Assuming the full-year shareholder return remains at $80 billion, the implied return rate based on the current $2.3 trillion market cap is 3.5%.

8. Key metrics compared to expectations

Dolphin Research's View

YouTube and the cloud business are visibly in a favorable development period, with little disagreement from the market. However, the expectation gap for the search business has persisted for several quarters, and in hindsight, the market seems to repeatedly fall into the trap of ghost stories, only to be disproven by the earnings report, resulting in a false alarm.

The comments from Apple executives in the second quarter further brought this risk issue to the forefront. Regarding this issue, Dolphin Research had a discussion at the time (Review), and although not optimistic in the medium to long term, we judged the market reaction at the time to be premature and excessive panic. The core logic is:

AI platforms led by GPT have not yet officially monetized through advertising, and the infrastructure of the advertising system and the commercial ecosystem with advertisers have not yet been established and perfected, far from the industry leader who has been immersed in the field for many years. This gives Google a time window to achieve transitional transformation and explore new business models, such as the later shocking debut of AI Mode, marking a key step in Google's self-revolution, bringing imaginative possibilities in new AI creation scenarios.

However, we also emphasize that while not pessimistic in the short term, a cautious and neutral perspective is still needed in the medium to long term. Rumors suggest that OpenAI will officially advance advertising commercialization next year, and while the commercial ecosystem may lag, there is always a strong new player in the advertising market. Even if merchants are only testing the waters with budget transfers, it will impact existing players, especially Google.

Therefore, regardless of how the short-term is disproven, the market quickly corrects the expectation gap, and this medium to long-term persistent risk and uncertainty will always hinder Google's valuation (currently 18x Forward P/E) from returning to the historical median, unable to match other Mag 7 giants (next lowest Meta at 25x).

In the previous quarter's commentary, due to the uncertainty of tariff impacts this year, Dolphin Research cited Google's historical changes in 2-year Forward P/E expectations, identifying 12x~15x as the historical valuation bottom for Google, with a short-term opportunity in this strike zone worth trying. Given the easing of tariff impacts, if following the normal growth trend, Google's 1-year Forward P/E valuation range is approximately a 15x bottom, a 22x median, and a 30x optimistic scenario.

However, considering the impact of AI search erosion (risk expectations), Dolphin Research believes that it will be very difficult for Google to maintain a valuation above the 20x median. Especially with the short-term suppression of antitrust litigation, the DOJ is set to announce a decision on the default search issue in early August, and whether it will be forced to split or remove the profit tie of Apple's "default" privilege will have a result. Although Google can still appeal, market sentiment may be affected at that time.

Below is a detailed interpretation of the financial report

I. Basic Introduction to Google

Google's parent company Alphabet has a wide range of businesses, and the financial report structure has changed multiple times. Those unfamiliar with Alphabet can first look at its business structure.

Briefly explain the long-term logic of Google's fundamentals:

a. The advertising business is the main revenue driver, contributing the majority of the company's profits. Search advertising faces a medium to long-term crisis of being eroded by information flow advertising, with high-growth streaming media YouTube filling the gap.

b. The cloud business is the company's second growth curve, having turned profitable, with strong recent signing momentum over the past year. As advertising continues to be dragged down by weak consumption, the development of the cloud business is increasingly important for supporting the company's performance and valuation imagination.

II. Steady Growth Despite Tariffs and Competition

Google's overall revenue in the second quarter was $96.4 billion, up 13.8% year-over-year, exceeding expectations. The core pillar, accounting for 75% of the advertising business, grew by 10.4% year-over-year, accelerating quarter-over-quarter. In addition to the currency tailwind, organic growth was also strong, with a 13.3% year-over-year increase.

Although the second quarter tariffs brought environmental turbulence, the strong foundation of the U.S. economy (quickly filling the gap left by reduced cross-border e-commerce advertising) and the growth drivers brought by Google's integration of AI with its business.

Beyond advertising, Google Cloud's performance driven by AI remained impressive, with a 31.7% year-over-year increase, exceeding market expectations.

Additionally, YouTube and Google One subscription revenue continued to drive other income growth, accelerating to 20%.

Specifically:

(1) Advertising: Tariff impact eases, steady growth

Advertising revenue in the second quarter was $71.3 billion, with overall growth of 7.9%. Core search and YouTube both maintained double-digit growth, accelerating quarter-over-quarter with the currency tailwind. The tariffs in April did have an impact, but due to policy swings, merchants quickly resumed advertising in May. Even though some significantly affected cross-border e-commerce (Temu & Shein) reduced their advertising scale, other advertisers quickly filled the vacated ad slots.

This essentially reflects Google's more competitive advertising recommendation and conversion system, with the integration of large model capabilities into various Google products having a positive effect. The integration of the Gemini large model in application scenarios (such as Google Shopping), the penetration of AI advertising tools among clients (such as Pmax), and the increase in user time spent in AI scenarios (such as AI Overview) have led more advertisers to recognize the improvement in ROAS brought by AI.

a. Search Advertising

Google's search revenue in the first quarter was $54.2 billion, up 11.7% year-over-year. AI Overview's penetration in search volume is not yet high and is mainly present in non-commercial searches. Commercial searches are still mostly presented in the traditional way, especially in Google's dominant advertising sectors (travel, finance, etc.).

However, the few ads present in AI Overview search results, although having a low click-through rate (requiring users to view more to see them), have more conversion potential. Advertisers at least recognize this. Due to the growth in user time/search volume under AI Overview and the scarcity of ad slots, advertisers are willing to accept higher eCPM bids.

Additionally, the combination of AI with original functions is also an important driver for improving advertising ROAS. For example, in Shopping, AI enhances content recommendations, and the front end improves personalized product recommendations based on user habits and preferences.

Regarding the impact of AI on search erosion, Google's market share loss is certain, but we tend to believe that the absolute value has not significantly decreased (AI drives users to engage in more rounds of dialogue). As for the issue of Safari's search volume declining for the first time, as mentioned by Apple executives, Dolphin Research tends to attribute it to differences in metrics (see detailed discussion inprevious discussion).

iOS users on mobile devices using Google search are not limited to Safari; they also include the Chrome app. Therefore, it is likely that users find the independent app's features more comprehensive for AI usage, resulting in a better experience. Additionally, core Google search users tend to download the independent app, while edge users use Chrome within Safari. These edge users are more likely to be captured by emerging AI platforms.

b. YouTube Advertising

YouTube, due to its brand advertising, is more sensitive to macroeconomic pressures compared to search. However, the short-term growth advantages of Shorts and CTV helped YouTube withstand some headwinds. The second quarter achieved $9.8 billion in advertising revenue, up 13% year-over-year, with a 1% currency tailwind.

c. Network Affiliate Advertising

Affiliate advertising revenue declined by 1.2% year-over-year in the second quarter. The higher the penetration of AI Overview, the more it should suppress this segment's revenue. Currently, affiliate advertising accounts for only 7.6% of total revenue, and the limited growth is likely mainly driven by advertising on Google's own products, such as Gmail.

For platforms that rely on Google for ad distribution, AI search Q&A provides a summarized version of the best answers, eliminating the need for users to click through links, thus significantly reducing the effective user clicks and behavior data obtained by distributors, affecting their advertising effectiveness.

(2) Cloud: Growth accelerates again, high prosperity continues

Although the market had certain expectations for high growth in the cloud business, it was likely due to high base and supply constraints that expectations for growth slightly slowed quarter-over-quarter. However, it actually accelerated to over 30%, with annualized revenue expected to reach $50 billion, growing at 30%+. Additionally, the operating profit margin of the cloud business continued to improve in the second quarter, reaching 20%.

The cloud business is To B, so its long-term trend may be related to its product competitiveness, but short-term changes are more likely to be influenced by the scale of new contracts signed in the current or previous period.

Therefore, Dolphin Research generally uses Google's Revenue Backlog indicator to judge short-term trends. Most of this indicator comes from the cloud business, so its trend can also be seen as the trend of the cloud business's unfulfilled contract volume.

Based on the contract scale situation, the slowdown in growth in the fourth quarter of last year rebounded in the first quarter, but it still decreased quarter-over-quarter, mainly due to a significant decline in new contracts in the first quarter. This may be due to environmental disturbances (Deepseek & tariffs) in the first quarter, and the second quarter data needs to be found in the complete annual report submitted to the SEC. However, given the company's confident move to raise Capex, there is no need for excessive concern.

For the contract backlog situation in the second quarter, Dolphin Research will update it in the Longbridge app's deep data module after the complete annual report is disclosed. Interested parties can follow it.

(3) Other Business: Driven by CTV & Google One, growth momentum maintained

This segment's revenue mainly consists of YouTube subscriptions (TV, music, etc.), Google Play, Google One, hardware (Pixel phones and Nest smart home appliances), etc.

In the second quarter, other revenue reached $11.2 billion, growing by 20% year-over-year, with the growth rate continuing to rebound, as shown in the Nielsen data above, it is likely mainly driven by the growth in subscription revenue from YouTube CTV and Google One.

III. Profitability: Increasing AI R&D + Employee Optimization, Simultaneously

The core main business's operating profit in the second quarter was $31.3 billion, growing by 14% year-over-year, with a profit margin of 32.4%, down 1.5 percentage points quarter-over-quarter. This was mainly due to a $1.4 billion settlement fee (2022 Texas data privacy lawsuit). Excluding this one-time impact, the actual profit margin remained at a high level from the first quarter, exceeding market expectations.

This also slightly exceeded Dolphin Research's expectations (expecting difficulty in improving profit margins), mainly because Google introduced a new voluntary departure program for traditional business employees in the second quarter, allowing voluntarily departing employees to receive a higher compensation package than before.

However, the number of employees still increased by over 1,300 in the second quarter, with expenses mainly growing in R&D. Therefore, it can be roughly judged that, like other Silicon Valley tech giants such as Meta, Google is continuously optimizing its workforce while maintaining high investment in AI-related technology R&D.

By business segment, the cloud business's profit margin further improved, already reaching 20% ahead of market expectations for two years later.

First-quarter capital expenditure was $22.4 billion, in line with market expectations. The GCP Next conference in mid-April reiterated the $75 billion Capex target, and within three months, it was boldly increased to $75 billion, demonstrating the advertising leader's determination for transformation and optimistic judgment on AI prospects.