GOOGL | Q2 2023

Operator: Welcome, everyone. Thank you for standing by for the Alphabet Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today, Jim Friedland, Director of Investor Relations. Please go ahead.

Jim Friedland: Thank you. Good afternoon, everyone and welcome to Alphabet's second quarter 2023 earnings conference call. With us today are Sundar Pichai, Philipp Schindler and Ruth Porat. Now, I’ll quickly cover the Safe Harbor. Some of the statements that we make today regarding our business, operations and financial performance maybe considered forward-looking and such statements involve a number of risks and uncertainties that could cause actual results to differ materially. For more information, please refer to the risk factors discussed in our most recent Form 10-K filed with the SEC. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of non-GAAP to GAAP measures is included in today's earnings press release, which is distributed and available to the public through our Investor Relations website located at abc.xyz/investor. Our comments will be on year-over-year comparisons unless we state otherwise. And now, I’ll turn the call over to Sundar.

Sundar Pichai: Thank you, Jim, and hello, everyone. We are holding our call from London today. It's an important hub for us, and I'm excited to spend time with our local teams, including Google DeepMind as well as leaders and partners from across the region. This quarter, we shared great progress at I/O, Brandcast and Google Marketing Live, and we are looking forward to Cloud Next in August. The momentum across the Company drove our results this quarter. We delivered solid performance in Search and YouTube and ongoing strong growth in Cloud, where we remain focused on long-term value creation. And we continue our important work to operate more efficiently, creating durable savings to fund investments in our biggest priorities. Today, I'll talk about this momentum, including our continued leadership in AI and our excitement about the evolution of Search. At I/O, we shared how we are making AI helpful for everyone in four important ways

Philipp Schindler: Thanks, Sundar, and hello, everyone. Happy to be here with you all today. Let's jump right into our performance for the quarter. Google Services revenues of $66 billion were up 5% year-on-year. In Google Advertising, Search and Other revenues grew 5% year-on-year, led by solid growth in the retail vertical. In YouTube ads, revenues were up 4% year-on-year, driven by growth in brand, followed by direct response, reflecting further stabilization in advertiser spend. In Network, revenues declined 5% year-on-year. Google Other revenues were up 24% year-on-year, led by strong growth in YouTube subscriptions revenues. Let's now take a few minutes to cover our 3 key priority areas

Ruth Porat: Thank you, Philipp. Before I go into the results, first, Sundar, thank you very much for the opportunity. I'm very excited about the new role, and I look forward to it. So, turning to the results. We're very pleased with our financial results for the second quarter, which reflect an acceleration of growth in Search and momentum in Cloud. My comments will be on year-over-year comparisons for the second quarter unless I state otherwise. I will start with results at the Alphabet level, followed by segment results and conclude with our outlook. For the second quarter, our consolidated revenues were $74.6 billion, up 7% or up 9% in constant currency. Search remained the largest contributor to revenue growth. Total cost of revenues was $31.9 billion, up 6%, driven by other cost of revenues of $19.4 billion, which was up 8%. Growth here was driven by content acquisition costs, primarily for YouTube subscription offerings, followed by hardware costs associated with Pixel family launches in the second quarter. As noted in our earnings release, the overall increase in data center and other operations costs was partially offset by a reduction in depreciation expense due to the change in estimated useful lives we discussed last quarter. Operating expenses were $20.9 billion, up 4%. Operating income was $21.8 billion, up 12%, and our operating margin was 29%. I will cover our expense and margin performance in our outlook. Other income and expense was $65 million. Net income was $18.4 billion. We delivered free cash flow of $21.8 billion in the second quarter and $71 billion for the trailing 12 months, reflecting improved operating performance as well as the deferral of certain tax payments to the fourth quarter of 2023 as noted in our earnings release. We ended the quarter with $118 billion in cash and marketable securities. Turning to our segment results. Prior period results have been recast for two changes that we made as of the first quarter. First, DeepMind is now reported as part of Alphabet's unallocated corporate costs. Second, we updated our cost allocation methodologies. In the second quarter, we then combined the Brain team from Google Research with DeepMind to form Google DeepMind. Costs associated with the Brain team, which were previously included in Google Services, are now reported as part of Alphabet's unallocated corporate costs. We have not recast prior period results to reflect this additional change. Within Google Services, revenues were $66.3 billion, up 5%. Google Search and other advertising revenues of $42.6 billion in the quarter were up 5%, led by growth in retail. YouTube advertising revenues of $7.7 billion were up 4%, driven by brand advertising, followed by direct response, reflecting further stabilization in spending by advertisers. Network advertising revenues of $7.9 billion were down 5%. Other revenues were $8.1 billion, up 24%, reflecting growth in YouTube non-advertising revenues, primarily from subscription growth in YouTube Music Premium and YouTube TV, followed by growth in hardware revenues, primarily driven by the launch of the Pixel 7a in the second quarter. Finally, Play returned to positive growth in the second quarter. TAC was $12.5 billion, up 3%. Google Services operating income was $23.5 billion, up 8%, and the operating margin was 35%. Turning to the Google Cloud segment. Revenues were $8 billion for the quarter, up 28%. GCP revenue growth remained strong across geographies, industries and products. That being said, we saw a continued moderation in the rate of consumption growth as consumers optimize their spend. Google Workspace strong revenue growth was driven by increases in both seats and average revenue per seat. Google Cloud had operating income of $395 million and the operating margin was 5%. As to our Other Bets, for the second quarter, revenues were $285 million, and the operating loss was $813 million. The decrease in operating loss was primarily driven by a reduction in valuation-based compensation liabilities related to certain Other Bets. Turning to our outlook for the business. With respect to Google Services, first, within advertising. We were pleased with the acceleration of Search advertising revenue growth in the second quarter. Our continued ability to generate sustained growth reflects our unparalleled engineering innovation that creates extraordinary experiences for users and capabilities for advertisers and delivered with the deep expertise of our go-to-market team. And in YouTube, we saw ongoing signs of stabilization in advertiser spending. We are prioritizing product focus on increasing quality consumption of video content with both Shorts and in the living room, which is translating into improved monetization. Second, within other revenues. In our YouTube subscription products, the sustained, strong growth in revenues reflects significant subscriber growth. You may have seen that last week, we increased subscription prices for YouTube Music and Premium, which underscores the value of the products. Strong year-on-year growth in hardware revenues was due, in large part, to a timing change given the Pixel 7a was launched in the second quarter, whereas the Pixel 6a launch occurred in the third quarter last year. Looking ahead, the launch timing change will be a headwind to hardware revenue growth in the third quarter. Play returned to positive growth in the second quarter, driven primarily by a solid increase in the number of buyers. Turning to Google Cloud. We are particularly excited about the customer interest in our AI-optimized infrastructure, our large language models, our AI platform services and our new generative AI offerings such as Duet AI for Google Workspace, although we are still clearly in the early days. At the same time, we continue to experience headwinds in the second quarter for moderation in consumption growth as customers optimize their spend. We continue to invest aggressively while remaining focused on profitable growth. In terms of expenses and profitability, we remain very focused on durably reengineering our cost base. Most evident to date are the actions we have taken to reduce the pace of headcount growth, including the workforce reductions we announced in the first quarter and a slower pace of organic hiring, in part given our focus on reallocating talent from within to fuel our growth priorities. A quick comment on the sequential improvement in operating margins in the second quarter. There are two factors to note. First, the benefit from an acceleration in search advertising revenue growth in the second quarter. Second, the vast majority of the charges related to our workforce reduction and optimization of our global office space were taken in Q1. Finally, as it relates to CapEx, in Q2, the largest component was for servers, which included a meaningful increase in our investments in AI compute. The sequential step up in the second quarter was lower than anticipated for two reasons. First, with respect to office facilities, we continue to moderate the pace of fit-outs and ground-up construction to reflect the slower expected pace of headcount growth. Second, there were delays in certain data center construction projects. We expect elevated levels of investment in our technical infrastructure increasing through the back half of 2023 and continuing to grow in 2024. The primary driver is to support the opportunities we see in AI across Alphabet, including investments in GPUs and proprietary TPUs as well as data center capacity. With all that said, we remain committed to durably reengineering our cost base in order to help create capacity for these investments in support of long-term, sustainable financial value. Thank you. Sundar, Philipp and I will now take your questions.

Operator: Thank you. [Operator Instructions] Our first question comes from Brian Nowak of Morgan Stanley. Please go ahead.

Brian Nowak: I have two. The first one for Sundar. Sundar, I'd be curious to learn about some of your early learnings and surprises around consumer behavior on how people are using Bard versus Search. And what new behaviors or consumer utility are you most excited about as you think about what Gemini could provide for people over the course of the next year or so? And then the second one for Ruth. Ruth, congrats on the new position. One question just about the durable expense comment. I think last quarter, you talked about the idea that expenses could grow slower than revenue in 2024. Is that still the right way to think about it? And just to confirm, does that include the impact of depreciation in those comments? Thanks.

Sundar Pichai: Thanks, Brian. I'll take the first part. It's definitely early days, but both across Bard and Search Generative Experience, feedback has been very positive from our users. I think we are definitely now able to serve, I would say, deeper and broader information use cases, which is very exciting. I wouldn't say surprised. So for example, people are really using it to -- for coding, something we understood, but it's definitely on the new side. There's a lot of excitement around -- we integrated Google Lens into Bard. We have known how big Google Lens can be. We see that in the visual searches we get and how much it has grown over the last two years, and so we've been doing this for a while. But definitely, that, in Bard, has been super well received. So which gives me a sense that as -- given Gemini is being built from the ground up to be multimodal, I think that's an area that's going to excite users. When I go back many years ago when we did universal search, whenever, for users, we can abstract different content types and put them in a seamless way, they tend to receive it well. And so I'm definitely excited about what's ahead.

Ruth Porat: And on your second question, Brian. We are really pleased with the operating performance in the second quarter. We've been saying for some time that we are focused on revenue growth ahead of expense growth and achieved that for the first in some time, and that is cost of sales plus operating expense overall. And we do remain very focused on durably reengineering our cost base. There are a lot of stream -- work streams that are in flight, and I mentioned a couple of them in opening comments. This remains a major priority as Sundar and I both commented on.

Operator: The next question comes from Eric Sheridan of Goldman Sachs. Please go ahead.

Eric Sheridan: Maybe one for Sundar and one also for Ruth. Sundar, can you talk a little bit about elements of open source versus closed and things like custom silicon and how you're thinking about AI offerings broadly developing over the next couple of years and what you see as some of the key differentiation points that Google, either through the cloud business or the consumer offerings, are going to bring to market, and how we should think about differentiation playing out to a greater degree in AI in the years ahead? That would be number one. And then, Ruth, I'll echo Brian's congrats as well on the new role. Maybe both of you could talk to why this type of role might be important at this point in time for Alphabet? And Ruth, what you're looking to sort of drive into the organization from this new role as you move into it in the fall. Thanks.

Sundar Pichai: Thanks Eric. On the first part, obviously, a big topic. I would broadly say, the investments for AI, when you look at the type of deep computer science work, the talent we have worked hard to bring to the Company, and from the ground up, the infrastructure we have built from the earliest days, Google has been a company, we've thought about the switches in our data centers, wherever we think we can do the best and get an advantage by innovating, we have chosen to do so. We have done that on AI, on the silicon side. But what's important to us is really stay focused on our users and customers and support all the innovations that's needed. So for example, with cloud, we've been -- we've really embraced open architecture. We have embraced customers wanting to be multi-cloud when it makes sense for them. So similarly, you would see with AI, we will embrace -- we will offer not just our first-party models, we'll offer third-party models, including open source models. I think open source has a critical role to play in this ecosystem. Google contributes -- we are one of the largest contributors to -- if you look at Hugging Face and in terms of the contribution there, when you look at projects like Android, Chromium and so on, Kubernetes and so on. So, we'll embrace that and we'll stay at the cutting edge of technology, and I think that will serve us well for the long term. On the second part of your question, first of all, I'm very grateful and thankful to all the work that Ruth has done for the Company. It's too invaluable to capture in words. I am super thrilled that she's going to continue on an impactful new role. And the scale of our company, with the broad changes in technology, I think it's more important than ever before to engage on these issues globally at scale and advocate on the economic opportunity of the investments we make across Alphabet and Google. And I'm glad that she's going to continue as CFO. And so no changes there, and we'll take the time to find a successor, and Ruth will be closely involved, not just on that, but also our long-range planning, including 2024. Ruth, anything to add?

Ruth Porat: Just to underscore, when you ask the point about impact, one of the places Sundar and I have discussed quite a bit is landing well the 2024 capital plan and the multiyear plan and completing all of the very important efforts we have underway. We're excited about what they mean, setting the company up well to be able to invest for long-term growth. And so we're continuing to execute against those. And then I think Sundar summarized it well. We see technology can make such a difference in the lives of so many and [in the lives of] (ph) economies. And to be able to focus on the impact on economic growth and the opportunity for people, for organizations, for countries, I think, is a privilege. I'm really excited about it, in particular, with this amazing company. And so focusing there as well as the investments that we make across Alphabet to drive economic growth globally across numerous sectors.

Operator: The next question comes from Doug Anmuth of JPMorgan. Please go ahead.

Doug Anmuth: One for Sundar and one for Ruth. For Sundar, curious, how do you think about timing for more broadly integrating generative AI into Search? And more specifically, what are some of the things you'll need to see to do that? And then, Ruth, just on CapEx, the 2Q CapEx is lower than expected, as you explained. Do you still expect modestly higher CapEx in '23 versus '22? And then, I know it's getting a little bit ahead, but how should we think about kind of timing of that real estate and office optimization efforts through '23 and then also into '24? Thanks.

Sundar Pichai: Look, on the Search Generative Experience, we definitely wanted to make sure we're thinking deeply from first principles. While it's exciting new technology, we've constantly been bringing in AI innovations into Search for the past few years, and this is the next step in that journey. But it is a big change, so we thought about from first principles. It really gives us a chance to now not always be constrained in the way Search was working before, allowed us to think outside the box. And I see that play out in the Experience. So I would say we are ahead of where I thought we'd be at this point in time. The feedback has been very positive. We've just improved our efficiency pretty dramatically since the product launch. The latency has improved significantly. We are keeping a very high bar, and -- but I would say we are ahead on all the metrics in terms of how we look at it internally and so couldn't be more pleased with it. And so you will see us continue to bring it to more and more users. And over time, this will just be how Search works. And so while it's -- we are taking deliberate steps, we are building the next major evolution in Search, and I'm pleased with how it's going so far.

Ruth Porat: In terms of CapEx, I tried to lay out sort of the cadence of CapEx, and the point was an important one that the sequential step up in the second quarter was lower than anticipated for the two reasons I noted

Operator: The next question comes from Lloyd Walmsley of UBS. Please go ahead.

Lloyd Walmsley: I wanted to just follow up on the -- some of the SGE questions and just get a sense -- I know it's early, but what are you seeing in terms of monetization? And how do you guys think about that as you scale up the deployment of SGE? Is that -- I think there's a lot of concern out there that maybe in the short term, it's a bit of a headwind. But over the longer term, maybe query growth from a more useful product can kind of kind of make up for that. But how do you guys see that playing out? And what can you share there?

Sundar Pichai: Maybe I can give some color here. We have obviously been focused on bringing this experience and making sure it works well for users. And it's very clear to me, first of all, as a user myself, there are certain queries for which the answers are so significantly better. It's a clear quality win. And so I think we are definitely headed in the right direction, and we can see it in our metrics and the feedback we are getting from our users as well. And the thing that doesn't change with these experiences is that many -- a lot of user journeys are commercial in nature. There are inherent commercial user needs. And what's exciting to me is that SGE gives us an opportunity to serve those needs again, better, right, and better. So it's clearly an exciting area. And as part of that, the fundamentals don't change. Users have commercial needs, and they are looking for choices, and there are merchants and advertisers looking to provide those choices. So, those fundamentals are true in SGE as well. And we have a number of experiments in flight, including ads, and we are pleased with the early results we are seeing. And so we will continue to evolve the experience, but I'm comfortable at what we are seeing, and we have a lot of experience working through these transitions, and we'll bring all those learnings here as well.

Operator: The next question comes from Justin Post of Bank of America. Please go ahead.

Justin Post: Great. Thank you. Just ask about the Cloud. It really looks like revenue growth stabilized despite optimization. So could you talk about the pipeline and the client wins in the quarter, how you felt about those? And then any uptick are you seeing related to AI spending in the total revenues this quarter or in the second half? Thank you.

Sundar Pichai: Thanks, Justin. Okay. It is an exciting moment overall in Cloud because there is definitely a lot of interest from customers on AI, and they definitely are engaging in many more conversations with us. So I would say, without commenting on the short term, but when I think about it long term, I view the AI opportunity as expanding our total addressable market and allows us to win new customers. Scale of investments that we can directly bring to cloud now. As I said earlier, we have over 80 models across Vertex, Enterprise Search and Conversational AI, and we are taking all of them, translating it into deep industry solutions. So, I'm excited about it. Second, it gives us an opportunity to upsell and cross-sell into our installed base. So for example, if you think about Duet AI in Google Workspace now, it's a collection of all our generative AI-powered collaboration features. We can bring it and make it available to more than 9 million paying Google Workspace customers. Similarly, with Duet AI in Google Cloud, again, allows us to go back to our installed base and engage in deeper conversations. And finally, I think AI helps us differentiate our core products. For example, if you take a look at cybersecurity, we are deeply incorporating AI to drive profound changes there. So overall, I'm excited, and I view this as a long-term opportunity. And all the investments we are doing in AI across Alphabet, including the work we are doing in Google DeepMind and Google Research on Gemini and so on are directly applicable to Cloud as well. So excited about it.

Justin Post: Great. Thank you. Maybe one follow-up for Ruth. Did the infrastructure cloud grow faster than Workspaces again this quarter?

Ruth Porat: So, we -- I don't think we commented on that. And yes, in the second quarter, GCP growth was above the growth rate for cloud overall.

Operator: The next question comes from Michael Nathanson of MoffettNathanson. Please go ahead.

Michael Nathanson: One for Philipp and one for Sundar. Philipp, can you talk about the ad market? If you step back, you're seeing real signs now of weakness in linear TV, ad agencies, small and digital companies were all slowing, and the macro backdrop is I think cloudy, yet you guys have accelerated your growth this quarter. What factors are you looking at? Do you see that would identify why are you growing while others are really struggling and slowing down? And then, Sundar, I think you spent over $100 billion on R&D over the past five years, and yet there's a narrative that it's so competitive and so expensive to compete going forward. Can you talk a bit about how you're visiting that R&D spend? Any near-term cadence updates you can give us for growth? And any factors that could change the growth going forward for research and development spending for you guys? Thanks.

Sundar Pichai: Look, maybe I can comment on the -- how we think about R&D. And look, if anything, I think two things. We are always committed to driving deep computer science research and innovation. That's the foundation on which the Company is built. And taking that and applying it and building new products and services and generating value is the virtuous cycle. And nothing changes in that fundamental thesis. We are definitely, both -- as Ruth mentioned, on AI investments, we are going to be committed to making sure we invest to realize the opportunity. But all the work we are doing on efficiency and optimization applies to -- on the AI side as well. And so we're bringing all that lens there so that we do this responsibly. But no overall changes in our philosophy or approach there. And maybe I'll let Philipp comment on the overall market dynamics.

Philipp Schindler: Yes. Look, I can't comment on others, but our focus continues, obviously, to be helping customers through whatever uncertainty or complexity they're facing, and a lot of companies are focused on profitability, driving efficiencies, and they're carefully evaluating the effectiveness of their budgets. And our goal is really to help them maximize efficiency and drive strong ROI. And I think we have the proven AI-powered tools and solutions to actually do it. I called out Search and Other revenues being led by solid growth in the retail vertical. We talked about the DR and brand side on the YouTube side. I think those are the key points I would make.

Operator: The next question comes from Ken Gawrelski of Wells Fargo. Please go ahead.

Ken Gawrelski: Can I ask on Performance Max? You've had great success there. Could you talk about any vertical or use case expansions? And how long until we possibly get to the point of more automated AI-generated creative in production?

Philipp Schindler: Yes. Look, this is a great question. AI is a foundational component that really allows us to help users advertise those pubs partners at scale. And we've been on a journey for years, right, to take the key components of advertising, whether it's bidding, targeting and creatives as well as innovation, frankly, in the core advertiser and publisher experiences and improve them dramatically through AI. And Performance Max is an example of how all this comes together at scale for advertisers. They provide us with a business goal, of assets, and we can then take care of the rest to meet consumer demand and really deliver on advertiser ROI. And as you heard it at GML, we've seen over many quarters, we continue to build new AI features really on top of this. I think I talked a bit in my prepared remarks about where we're taking some of our products from a gen AI perspective. And if you take a look at some of the things we announced there, it's fair to say, whether you look at our revamped asset creation flow in Performance Max, whether you look at Automatically Created Assets, whether you look at Product Studio and so on, there we're on a right path to deliver some really exciting new innovation in automated -- let me call it, asset creation in the broader sense.

Operator: Our last question comes from Mark Mahaney of Evercore. Please go ahead.

Mark Mahaney: Okay. Actually, I'll follow up on that last question, Philipp. You pointed out AI has been used to improve the advertising mousetrap at Google for many years. Do you view generative AI as just a material accelerant of your ability to improve return on ad spend for the millions of marketers who use Google? And if you think about where generative AI would have the most impact, could you peel it apart, what's your guess now over the next couple of years where it's going to have the most impact on the creative, on the audience creation, on the campaign optimization? Where do you think the most impact will come from generative AI, just for all the -- your advertising customers? Thanks.

Philipp Schindler: Look, as I said earlier, generative AI is supercharging new and existing ads products with really tons of potential ahead. And we're really helping advertisers here make better decisions, solve problems, enhance creativity. And I covered this earlier. For example, we launched a new conversational experience in Google Ads, the asset creation flow in PMax. I mentioned the Automatically Created Assets, the Product Studio and so on. When I talk to customers, they're very excited about AI, and understandably, have some questions. One of the top questions is, for example, what's the next best step I should take. And this is a key reason why we launched our Google Ads AI Essentials, which was a big announcement at GML. It's a checklist of simple steps customers can take right now to unlock the power of AI, and it has to do with the foundation of data and measurement. It has to do with taking action with our AI products and really is a mindset shift to set up organizations for AI success. So those are just some of the examples. If you extrapolate those going forward, those are some of the examples where I see a lot of upside, apart from the points that Sundar already mentioned.

Sundar Pichai: And I think all of this is before we have multimodal capabilities really in the mix. And so, looking at the early innovations there, I think it's going to be an exciting couple of years ahead. Thanks, Mark.

Mark Mahaney: Thanks, Sundar. Thank you, Philipp. Congratulations, Ruth.

Operator: Thank you. And that concludes our question-and-answer session for today. I'd like to turn the conference back over to Jim Friedland for any further remarks.

Jim Friedland: Thanks, everyone, for joining us today. We look forward to speaking with you again on our third quarter 2023 call. Thank you, and have a good evening.

Operator: Thank you, everyone. This concludes today's conference call. Thank you for participating. You may now disconnect.