3 Tailwinds that could make a big difference in 2023
Last month we published an article outlining our bullish thesis for Google which centered around an enormous, performance-centered compensation package for CEO Sundar Pichai. In that article we predicted that Google would roll out new initiatives, cost-cutting measures, and other changes to the business that would better serve shareholders, and that the company’s relative slowness to announce large scale changes was tied to finalization of Pichai’s comp plan.
After this earnings call, we still think our thesis was a good one, but there are some exciting new developments. Google’s announcement of its Q4 earnings also came with a built-in tailwind for the business that will improve operating margins in the quarters to come.
But before we get into that, let’s take a quick dive into the numbers.
By The Numbers
Revenue in the 4th quarter grew 1% overall (7% on a currency-neutral basis) to $76 billion, while yearly revenue was up 10% (14% currency-neutral) to $282 billion.
Most of the headlines around the numbers came in the form of panic around the reduction in ad spend, which impacted the bottom line. Diluted EPS declined from $5.62 in 2021 to $4.56 in 2022, with operating margin being squeezed from 31% to 26%.
First off, the decline in ad spend should not be a surprise in the current macro environment. With a recession on the horizon, companies are expected to tighten their belts and reduce their marketing budgets. While Google’s stock dropped on the day of the earnings announcement at this news, we remind investors that this situation will resolve itself as the macro picture improves throughout the year.
The low-boil panic over the decline in YouTube revenue is, for the same reason, a blip on the long-term radar, in our opinion. Aside from search, YouTube is Alphabet’s most valuable property and, we believe, the one with the most monetization potential in the future.
There are many other articles you can read, however, that dive into these numbers. In our opinion, Google delivered a strong quarter overall that was impacted by temporary economic and FX headwinds. For what it’s worth, CFO Ruth Porat noted that the company had repurchased an incredible $59 billion of its own Class A and C shares (time for a dividend, anyone?).
What we want to focus on, however, are the subtle financial and accounting changes that we think will provide a boost for the stock in the remainder of the year.
The primary focus aside from decreased ad spend was the compression of operating margin in Q4. We want to demonstrate why we believe these headwinds will be eliminated and benefit the stock in 2023.
First up, inventory. Google’s inventory jumped significantly in Q4.
This surge of almost 50% from $2 billion to roughly $3 billion in inventory held by Google was a major factor in the 15% rise of Cost of Revenues, which squeezed Google’s operating margin and profit for the year.
Management did not provide much of any color about this rise in inventory on the call, but we find the timing curious. First, it’s exceedingly unlikely that Google expects Pixel and Fitbit sales to jump by 50%. It’s also unlikely that Google’s management simply lost cost discipline and went spend-crazy.
In our view it’s more likely that the company loaded up on inventory during a quarter when expectations were already low and investors were expecting margin compression. We believe this inventory load-up, then, is not indicative of massive, pent-up demand (though demand is growing), but a stocking up to reflect mainly management’s view that pricing pressure will continue upward. As CFO Ruth Porat said, the change “reflect[s] ongoing pricing pressures and changes in expected future inventory needs”.
We expect that inventory levels will revert to normal levels over the next few quarters as the company sells products through and resumes normal levels of restocking. We believe the effect of this will be reduced pressure on operating margin as Cost of Revenue decreases from Q4 2022 highs.
Layoffs & Reserves
We predicted that Google would conduct layoffs in 2023. In January, the company did just that, announcing that it would reduce headcount by 12,000. For this, the company announced that it would set aside anywhere from $1.9-2.3 billion to cover severance-related charges.
Doing the quick math and assuming that the company uses $2.1 billion of the allowance, the average severance works out to around $175,000. Given that the layoffs seem to be centered around non-technical positions and the fact that the company continued to onboard new technical in Q4, this figure seems a little high.
In short, we suspect that Google may not need or use the entirety of the reserve. We should point out that there’s nothing nefarious here–it’s just a function of the accounting rules.
When Google announces its Q1 earnings, we will be watching to see how much Google actually expended and how much its headcount actually reduced. In Q1 this expense will be allocated on the balance sheet and will show up on the income statement as well. If the company does not use the full amount, the reserve will be released and provide a bump to the balance sheet and a reduction of forecasted costs.
Change In Depreciation Accounting
Tucked away in Google’s earnings release and in a Change In Accounting Estimate on page 40 of its 10K, Google announced that it had completed a study in January 2023 that determined that the useful life of some of its servers and other equipment could be extended from five years to six.
This is a big deal.
Extending useful life can result in material changes for a company’s operating profit as it reduces the amount of depreciation that must be recorded. And yes, while depreciation is a non-cash charge, operating profit and margin are closely watched figures by Wall Street and investors–so any boost helps.
In this case, the resulting tailwind for operating profit is estimated to be $3.4 billion in 2023. In 2022, Google had total depreciation costs of about $15 billion (the company rolls up its depreciation expense in its overall costs on the income statement but breaks it out in the cash flow statement).
Reducing depreciation costs by about 15% in the next fiscal year could provide an almost 1% increase in operating margin.
Putting It All Together
These three boosts–an anticipated reduction in inventory spend, a possible surplus of severance set aside, and an extension of useful life, should help position Google for reporting success even if the macro outlook fails to completely recover. And just for clarity–we do not believe that these three items alone, if they come to pass in the way we expect, will be enough to spell success for Google. We simply believe that these elements help to ‘stack the deck’ in the company’s favor, and even a small amount of edge can be enough to help investors assess a company’s prospects.
There are plenty of other reasons to be positive about Google–add into the mix that the dollar has fallen off its 2022 rally highs, the continued monetization of YouTube shorts, and the breakout of DeepMind and into its own reporting segment, and we see the headwinds for Google largely abating in the quarters ahead. We will be keeping an eye on the company in the coming months to see how these items play out, and we recommend that investors do the same. Seeking Alpha
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