Alphabet Inc - Class A (GOOGL) — Q3 2019 Earnings Call Transcript

Thank you. Good afternoon, everyone, and welcome to Alphabet's third quarter 2019 earnings conference call. With us today are Sundar Pichai and Ruth Porat.

Thank you, Ellen, and good afternoon. Q3 was another great quarter at Google with strong revenue growth driven by mobile search, YouTube, and Cloud. We celebrated Google's 21st birthday this quarter. While our mission to organize the world's information and make it universally accessible and useful hasn't changed, we've evolved from a company that helps people find answers to a company that helps you get things done. Since the beginning, we've always invested in tackling deep computer science problems that can have a significant impact on society. The chance to be part of these fundamental engineering challenges is why so many people want to work at Google. In just the last week we have announced two significant advances. First, powered by our long-term investment in AI, we dramatically improved our understanding of the questions people ask Google Search. It's the biggest leap forward for search in the past five years. It’s all possible because of a new type of neural network-based technique for natural language processing called BERT, which recognizes subtle patterns in language and provides more relevant results. Second, we recently announced a major quantum computing milestone. I was extraordinarily proud to visit our team in Santa Barbara. To demonstrate supremacy, Google's 53-qubit quantum machine Sycamore successfully performed a test computation in just 200 seconds that would have taken the most powerful supercomputers much longer to accomplish. It's the Hello, World! moment we’ve been waiting for and represents a distinct milestone in our effort to harness the principles of quantum mechanics to solve computational problems. Turning from quantum to the quarter. Today, I'll talk about the momentum we saw across the business in the last three months. First, Cloud. We saw customer momentum across multiple areas under Thomas’ leadership. In September, we announced a landmark partnership with Mayo Clinic. Using Google Cloud to secure and store data and understand insights at scale, Mayo Clinic will partner with us in many ways. Together, we'll work to transform patient and clinician experiences, identify new methods of diagnosing diseases, conduct clinical research, and find new models for delivering patient care.

Thank you, Sundar. In the third quarter, total revenues of $40.5 billion were up 20% year-on-year and up 22% in constant currency. Once again, our results were driven by ongoing strength in mobile search, YouTube, and Cloud. I will begin with the review of the quarter on a consolidated basis for Alphabet, focusing on year-over-year changes. I will then review results for Google, followed by other Bets and conclude with our outlook. Sundar and I will then take your questions. Details of Alphabet’s consolidated revenues by geographic region are available in our earnings press release. Regarding our key expense lines, on a consolidated basis, total cost of revenues, including TAC, which I will discuss in the Google segment, was $17.6 billion, up 23% year-on-year. Other cost of revenues on a consolidated basis was $10.1 billion, up 31% year-over-year, primarily driven by Google-related expenses. The biggest contributor again this quarter was costs associated with our data centers and other operations including depreciation, followed by content acquisition costs, primarily for YouTube and mostly for our advertising-supported content, but also for our newer subscription businesses, YouTube Premium and YouTube TV, which have higher customer acquisition costs as a percentage of their revenues. This line also includes the impact of hardware costs, primarily associated with our mid-tier Pixel 3a smartphones. Operating expenses were $13.8 billion, with headcount growth being the largest driver of year-on-year growth for both R&D and sales and marketing, which is reflected in both compensation and facilities expenses. With respect to R&D, the growth was again driven by the addition of engineering talent, consistent with our focus on product innovation. The increase in general and administrative expenses year-over-year was primarily due to a $554 million charge from our previously announced legal settlements in France. Stock-based compensation totaled $2.6 billion. Headcount was up 6,450 from the second quarter. And consistent with prior quarters, the majority of new hires were engineers and product managers. In terms of product areas, the most sizable headcount increases were again in cloud for both technical and sales roles. Operating income was $9.2 billion, up 6% year-over-year for an operating margin of 23%. Other income and expense was a loss of $549 million, which primarily reflects the impact of unrealized losses on marketable equity securities. As of September 30, the unrealized equity gain in the combined portfolio of marketable and nonmarketable securities was $5.8 billion. We provide more detail on the line items within other income and expense in our earnings press release. Net income was $7.1 billion and earnings per diluted share were $10.12.

Thanks for taking the questions. Maybe two, if I can. First, Sundar, big picture question. It feels like the concept of ambient computing was sort of prevalent at the Made by Google event recently. It started with sort of a bit of a shift in theme, what I could tell at Google I/O earlier this year. Can you just talk about what some of the key investments you want to make to capitalize on that opportunity long-term? How you think Google and maybe broader Alphabet is positioned to capitalize on that? How it might show up at the product services layer? So, I guess, maybe a three-part question, more of a bigger picture nature.

Thanks, Eric. We are very excited by the vision of ambient computing and evolving that. I think it's a continuity in the sense that over time computing should be more intuitive to users, and computing should adapt to users, not the other way around. And the foundations of all of this is all the work we have done with our computing platforms to date and under successful consumer services and developer platforms we have built. And I think that's where most of the investments there are. The phones will continue to be at the center of ambient computing for the future. So, that's another important piece where we are already invested. I think, as we expand beyond, and that's what the Made by Google family is focused on, products in your home with our Nest family of products, and wearables which we do with Wear OS and so on. So, supporting that ecosystem, whether you're at home, on the go, or at work, and making sure it works. Our investments in AI across the company, I think, will end up playing a key role; AI and Assistant will be at the center of making sure we can anticipate what users want and serve them better.

Sundar, you talked about the new neural network techniques talking about the biggest breakthrough in Search in years. Could you just help us understand if that’s impacting kind of the advertising and monetization side of the business yet or how that can play out going forward?

Anytime I can explain it as BERT, which is the technique we're implementing in Search now. Whenever we enhance our understanding of queries, we can better serve users, improving our search quality and increasing user engagement. This initiative is part of our long-term efforts, and it represents a significant advancement in enhancing the search experience and quality. It's worth noting that it will benefit specific types of queries. While many queries are already functioning well, this will help us capture nuances and better grasp human context. I see this as a major enhancement that boosts search quality and fosters a positive feedback loop that encourages user engagement. Additionally, we often apply similar techniques on the app side, and in the future, we will implement machine learning strategies there as well.

I just wanted to follow up on a couple of the comments you made about Cloud, Sundar. I was wondering if you could just give us some color on the size of your GCP backlog. And maybe even if you just talk about the trajectory, and how that's changed over the course of the last year? And then, you mentioned the strength and the uptake of BigQuery; I'm just trying to think through how we should think of the margin, level of a service like this versus the traditional compute offerings where you've seen strength to date. And just wondering if we start to see some positive mix shifts benefits, as some of these premium products start to ramp more aggressively? Thank you.

Thanks, Heather. Overall, I know, we gave some visibility into our cloud business and we'll continue to do that periodically. And the momentum has been great. Obviously, ever since Thomas has come in, he has continued to invest across the board. He’s definitely focused a lot on scaling up our sales partner and operational teams, and it's playing out well. In this business, it’s important for you to be in as many deal situations as possible and get those wins, which accrues over time. And so, we are definitely seeing the momentum. Analytics is a huge area of strength for us. It’s an area in which Thomas has a lot of expertise as well. BigQuery is such a strong product, so it's a natural area where we are seeing strength. My sense is that as we look at the total addressable market, the percentage of total addressable market for which we were eligible, compared to two years ago, last year, and now, that number is shifting aggressively due to either completing our product feature set or completing some of the certifications we need. There are several strong forward-looking indicators, and I look forward to sharing more at the right time.

Could you elaborate a bit more on Google Maps? I understand there were marketing efforts earlier this year, and it seems like it's at a point where it's going to be better integrated into the purchasing process or however you're making it easier for small businesses to access what should be well-qualified leads. Can you discuss the speed at which monetization or ad opportunities will be available to small businesses? Thank you.

In general, local is an important area for us, and we are continuing to invest in building experiences that connect merchants, advertisers, and users. Google My Business has been our major effort there. Today millions of businesses reach and engage both through Search and Maps. Specifically, in Google My Business, we announced that we will expand local campaigns. I presume that's what you're talking about. It's still early. In general, we want to make it easier for advertisers, particularly small and medium businesses, to come to Google and reach users across our set of owned and operated properties. So, be it Search, be it YouTube, be it Discover, be it Maps, and that's how we envision that. Small and medium business is a big area of focus, and Maps represents a significant long-term opportunity for us.

And just to add on there, given you referenced back to Google My Business, and I think we talked about this last quarter as well. Our view is that the products that were introduced to Google My Business this year, like in previous years, they're rolled out in phases, they're adopted over time. So, we don't view the potential impact from this year's slate differently than the impact from products that were launched at previous events, and so just to keep that in perspective.

I wanted to ask another question about the new product you guys announced earlier this year at Google Marketing Live. And that was really Google Shopping and moving that across some of the new different properties like YouTube and Image Search and Discover. Can you give us a sense for where you are in that migration, kind of over what timeframe should we be thinking about that? And then, maybe just elaborate a bit on the long-term vision of moving shopping functionality into properties like YouTube and how you think that experience will evolve? Thanks.

In general, I think it’s a paid opportunity for us. We see tons of what I would call commercial user journeys across Google. Obviously Search is an important area, Image Search, YouTube, Maps — all great surfaces by which I think users come with varying degrees of commercial interest, looking to discover and at times transact. We’ve started thinking much more holistically about what are those experiences and how can we make it better. That involves helping improve the Discovery experience, but when people are interested, being able to make it easier to transact. The equivalent of being signed in and being able to pay when you want, and then of course fulfilling and logistics. We are thinking through the end-to-end experience across all our surfaces and are investing in that. I see the user interest, and it’s an area that I believe we have significant opportunities ahead.

These are still early stage projects, and we're excited about the potential long-term impact. However, I want to emphasize that we are still in the initial phases of testing.

Thanks for taking my questions. I have two. Ruth, I think you mentioned that Desktop Search might have been one of the contributors to growth. Can you just talk to us a little bit about what types of products or verticals you’re still seeing growth? I know desktop search is really impressive, given how long it has been around. And then, Sundar, with all the exciting changes going on with search becoming more relevant, etc. Can you just talk about some of the KPIs that you monitor or what you're seeing when it comes to query volumes, click-through rate, overall response time; what are you seeing that sort of gives you confidence that you’ll continue to get more relevant results for your users? Thanks.

So, in terms of desktop, I described it as a solid contributor to revenue growth. What we see is that desktop does remain an important form factor for certain more complex tasks. So, things like planning vacations or assessing insurance options, users continue to go back to desktop, notwithstanding the growing utility of mobile. One of the things that we’ve been very focused on is that innovations that benefit mobile also enhance the desktop experience for users and advertisers.

And then, in terms of — obviously, we’ve developed a very comprehensive metric for measuring and tracking search quality — to get a sense of such quality and how user satisfaction is through search. We continue to take this work deeper. We realize users sometimes do searches through sessions, understanding what is their satisfaction across the session, what is their engagement, are they finding what they are looking for? Those are all some of the deeper work we are undertaking, and also understanding by vertical how we are helping users. There was an earlier question around shopping and commerce; that's an example of the kind of vertical and what we can do to make that experience better. Health is another vertical in which we have a whole Google Health team focused on understanding the in-depth experience that would give better results overall in search. So, it's a comprehensive effort, and we are constantly looking to expand both deeper and broader.

I have two. Sundar, there's clearly a lot of innovation happening at Google. But, I'm wondering how do you think about the increase in scrutiny and oversight possibly impacting your ability to explore new services or new markets over time, and ultimately to remain competitive? And second, Sundar or Ruth, we don't often ask about the display network, but just wondering, given all the concerns around privacy, ad blocking, and the like, how do you view this business strategically as part of the overall ecosystem?

On the first part, we consistently want to work and build products that benefit users and support the ecosystem. Our products and services benefit consumers, small and medium businesses, advertisers, and overall, they help reduce prices and expand choice. That’s our underlying approach, which helps us engage and explain to regulators, and we’ll continue to do that. There are many new areas of opportunities available for us, and in many of these areas, we are the new entrant, creating competition. Sometimes the competitive pressures can lead to concerns from others, and that’s part of what’s going on as well. But, in addition to developed markets, we are investing deeply in our next billion users; markets like APAC continue to be long-term opportunities for us as well.

Ruth, if you rewind the clock a little bit, when we entered this year, you had called out how some product changes may cause year-over-year growth rates to fluctuate from time to time. And we haven't heard that in a couple of quarters. So, as we look out towards like 2020 and beyond, do you feel like a lot of the product queue is in a good place as far as Search and YouTube are concerned, and that these product changes might be a little bit more subtle going forward, or could we return to having more meaningful impact in the future, just any color there? And then, on the third quarter, the Asia region, the growth rate was solid but a tad lower than the prior trend. So, anything notable to call out on APAC?

In terms of the first question, I think, as Sundar and I discussed, we're pleased with the strength of the business that you've seen here again in the third quarter. Since the IPO, we don't manage the business to maximize quarterly results, and we'll always do the right thing for the long term. We're focused on investing for the long term. I tried to make it clear in my opening comments that as a result, quarterly growth can vary and has varied. In terms of your question about geographies, when we look at the performance on a fixed FX basis around the globe, we are pleased with the performance again in the third quarter. As you pointed out, the year-on-year growth in APAC in the third quarter was a bit lower than the second quarter. That primarily reflected slower growth in the network business, which was in part due to policy changes. It also reflected the fact that the launch of the Pixel 3a was in the second quarter, which boosted the year-on-year growth rate in the second quarter. But implicit in your question, at 26% year-on-year growth on a fixed FX basis, running at about now $7 billion in quarterly revenues, we’re really pleased with all that the team is doing and the year-on-year growth rate.

Sundar, maybe you could give us a little bit of an update on the Discover feed. That's a new product that we featured in the past that I know a lot of users are getting more use out of. You gave us, I think, some updates on monthly active users or daily active users in the past. Any updates would be great, or maybe any additional color on sort of how the total amount of usage goes on there, that's obviously been featured to users a little bit more. And then, second, maybe just a follow-up for Ruth. Sundar spoke at length about your investments in renewable energy earlier, and maybe keeping with the theme of the earnings call. You could help us understand how that is, or maybe is not, helping drive efficiencies across the company and your operating costs overall? Thanks.

Discover is a product we are very excited about. I think it completes the other half of Search. Search is where we do our mission for our users and be helpful when they come to us looking for information, and Discover is the other half, where we are proactively understanding what might be most helpful or relevant to them and getting it to them. We are definitely focused on product quality and making sure the product is actually helpful to users, and when they engage with it, they find it useful. We are making progress here. Our investments in machine learning are helping us well, allowing us to better anticipate and give them information proactively. Over time, I see it as an important area for us. It's part of our search and knowledge efforts. As we do this, you can imagine, you might have started a query in Search, and it's a session; perhaps you're looking to take a trip somewhere, or researching a particular topic; we may be able to continue that conversation on the user journey in Discover, and that creates a virtuous cycle. We want to be helpful to users in a way that makes sense for them, more continually, and the combination of Search and Discover helps us do that.

And in terms of your question on sustainability, we're proud of the work that we're doing. We do think that it’s a valuable part of what we do, and we do consider the impact on the business and on the financials. It really cuts across every element of what we do — our technical infrastructure, the way we’re thinking about our products that Sundar talked about, what we're doing with our facilities, and what we're doing with AI. About a year ago, we talked about how we were applying machine learning to energy efficiency in our data centers, and it had a net benefit. It helped us reduce energy consumption, which was positive for sustainability but also an efficiency effort. Sundar talked about the fact that we are investing — recently announced that we are purchasing and making an equal investment in renewable energy, part of our commitment to offset 100% of our electricity use with renewable. We believe this is catalyzing further investment in renewable. That is going to have a modest short-term increase in cost. However, we think it’s beneficial to catalyzing the overall growth in traditional energy. There are puts and takes, and we’re proud of the work across everything that we are doing to support sustainability.

So, Sundar, I was wondering if you can put the quantum computing investment into some sort of perspective. Compute needs for Google have to be exponentially higher versus when you first launched. So, we’re wondering if this helps you get your arms around that ever-increasing compute need. And further, I think you’ll find that investors are as impatient as you guys are for progress. So, can you talk about what kind of products or services this will help you create that you other couldn’t even think about doing before? Thanks.

I’m incredibly proud of the work that the team did and excited about the advancement in the whole industry. In general, we’ve relied on advances in computing to do what we do. When we look ahead, we definitely see that being able to drive the pace of change here fastest is an important need for us as well as a source of competitive advantage. As Moore’s Law effects have diminished, we are looking at a variety of approaches to make sure we can continue doing what we need to. In that sense, this is an important tool in our arsenal. While quantum will take many years to really start making a difference, we want to be at the cutting edge of driving it. I don’t think over time for sure, cloud itself, we see a lot of interest from cloud customers, particularly in cutting-edge verticals, about quantum computing. This is an area where we believe we’ll participate as a business and, more importantly, we’ll apply it across other verticals we are in, such as health; that’s an example where I think we will be delivering value in the long run.

As much as we're extremely excited about the long-term implications for quantum computing, part of your question regarding our near-term computing requirements shows that, given our outlook, particularly across Google, we do expect to see ongoing demand for compute investments to support our growth, particularly for machine learning, Cloud, Search, and YouTube. The primary driver of the CapEx continues to be our expectations for compute requirements, so investments in technical infrastructure, as we've talked about today.

Thanks. I need a Google headset. Sundar, just on investments in GCP, you're in a really unique situation, having built infrastructure and productivity applications. Can you just walk through how you prioritize the two big buckets? There are a lot of different ways you can go in GCP. And just want to follow up with Ruth. You alluded to some G Suite pricing changes. I know there were some prices that were changed earlier in the year, and I was just curious if you were referring to that price change or earlier in the year or if there was something new?

You're right. These are two big buckets, and we treat them that way. Obviously, we've talked a lot about GCP, but G Suite continues to be very differentiated. We just announced a new leader, Javier Soltero, coming in with lots of experience to turbo-charge this area as well. In general, there are many G Suite customers now with whom we are having GCP conversations and vice versa. Given we have a big go-to-market effort, the breadth you have allows us to have more conversations and engage through many different paths into the organization. It’s a very synergistic relationship as well.

In terms of the G Suite pricing, I was referencing the pricing that we announced back in April. It's all outlined in a blog post. Our view was that it was the right time to increase prices, given the ongoing functionality and tools that are included within G Suite. As I said, what we're seeing here is in addition to the benefit from the price change, we also continue to have nice seat growth.

I think I’ll ask on YouTube; could you talk a little bit about your high-level OTT viewing strategy? Obviously, subscriptions are growing. Maybe give us an update on how your YouTube subscription product is doing versus expectations? And then, on the paid click growth, it decelerated 18%, anything to call out there, especially related to YouTube, any change to coverage going on or anything we should know about? Thank you.

Subscription is an area we are definitely excited about. We are pleased with our options so far across both YouTube Music and YouTube Premium. They are now available in 71 countries, up from five markets at the start of 2018. We are scaling that up and are seeing great traction. YouTube TV is also doing well. I think we just announced that PBS is coming to YouTube TV in July. Last month, we announced that YouTube TV is now launching on select Amazon Fire TV devices. The user satisfaction for the product is high, and we are focused on continuing our expansion, building out a great service, and building awareness for the service. Overall, I think engaging users with premium offerings on YouTube is our focus, and the efforts, while early, are definitely showing strong traction.

You asked about click growth and the trend there; the biggest driver affecting the click trends continues to be the growth of YouTube engagement ads. In the first and second quarters, the rate of YouTube click growth decelerated in the third quarter. That continues to reflect the changes that we made in early 2018 to really improve the user and advertiser experience. As we discussed on prior calls, those changes were not related to policy enforcement actions on YouTube, and they had a negligible impact on YouTube revenues, so there’s no need for concern.

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