Morning Note: Market news and updates from Alphabet and Visa.

Market News

US equities moved higher last night – S&P 500 (+0.2%); Nasdaq (+0.8%) – and continued to rise after hours on the back on good results from Alphabet and Visa (see below). Microsoft and Facebook owner Meta Platforms report this evening.

The recent bond market sell-off leaves US Treasuries on track for their worse month in two years. The 10-year currently yields 4.25%. Gold continues to make new highs and currently trades at $2,780 an ounce.

In Asia this morning, equity markets were mixed: Nikkei 225 (+1.0%); Hang Seng (-1.6%); Shanghai Composite (-0.6%). The BOJ is widely expected to stand pat tomorrow in the face of elevated uncertainty. Governor Kazuo Ueda will probably wait and see how the US presidential election and Japan’s political instability affect the economy and financial markets.

The FTSE 100 is currently trading 0.5% lower at 8,180. Ahead of today’s Budget, Sterling trades at $1.3010 and €1.2022. It is expected to include about £35bn in tax hikes and spending cuts with room to borrow more. The Times reported it will include a £3bn boost to defence spending.

Brent Crude held steady at $71.20 a barrel. According to Saudi Aramco’s CEO Amin Nasser, global oil demand is expected to rise by about 1.5m barrels a day next year, while BP’s CEO believes a surge in energy demand from tech giants is becoming a major boon for the fossil fuel industry.

The EU imposed higher tariffs on EVs from China ranging up to about 45%, following months of negotiations, threats of retaliation and auto-industry pleas to avoid escalation.

Source: Bloomberg

Company News

Last night, Alphabet released quarterly results which were better than market expectations, reflecting strong momentum across the business especially in cloud and subscriptions. The shares were up 6% in after-hours trading.

Alphabet is the public holding company for Google, one of the world’s most recognised and widely used brands. In addition to the core search engine, the group owns digital video platform YouTube, Google Cloud, web browser Chrome, mobile operating system Android, Gmail, Google Maps, Fitbit, and autonomous driving company Waymo, among others.

The group has a strong track record of innovation, leaving it well placed to capitalise on a wide variety of technological themes, such as digital media, e-commerce, video advertising, the cloud, the internet of things, driverless cars, and artificial intelligence. We believe the shift to internet-connected devices and streamed TV means the growth of advertising dollars on Google Search and YouTube has much further to run. Machine learning capabilities should also help advertisers get higher return on investment and encourage them to continue to allocate their advertising budgets to Google.

The company has six products with more than two billion users each and another nine with more than 500m users, most of which we believe are far from being fully monetised. The group’s structure allows it to own a portfolio of businesses with different time horizons, while its broad offering provides a competitive edge. Capital allocation is strong and spread across internal R&D, accretive M&A, and massive shareholder returns.

Alphabet has continued to launch a range of innovative devices, tools, and features, many of which are designed to make AI more helpful. Recent launches include the next generation of Pixel smartphones with AI features, Gemini Live (a conversational AI assistant), and the Pixel Watch 3 with new advanced fitness experiences from Fitbit.

Political and regulatory headwinds have become more elevated in recent months. Most importantly, in August a US Federal judge ruled Google acted illegally to maintain a monopoly in search, including the use of search commercial agreements. In October, the DOJ filed its high-level remedies framework which included:

·       limiting/ending the use of distribution contracts with third parties

·       sharing of data and search results with the competition

·       restrictions on the development of Google’s AI models

·       restrictions on the use of Chrome, Android, and Google Play.

·       the separation of Chrome or Android from Google or a full break-up of the company.

The final proposals are due on 20 November with the final ruling not until next August, following which there is likely to be an appeal. As a result, in the absence of a settlement, the case is likely to drag on for years. There is also an AdTech trial for which the judge is due to rule by the end of 2024. Overall, we believe the current valuation of the shares already discounts many of the less favourable outcomes, albeit not the worst-case scenario.

Back to last night’s results. In the three months to 30 September 2024, revenue grew by 16% on a constant currency basis to $88.3bn, above the consensus forecast of $86.2bn, and reflecting strong momentum across the business.

The group reports its results across three segments: Google Services, Google Cloud, and Other Bets. Google Services is the largest division (% of revenue), generates revenue primarily from digital advertising and the sale of apps, digital content products, hardware, and YouTube subscription fees. During Q3, Google Services revenue grew by 13% to $76.5bn.

Google Search (which accounts for 75% of ad revenue) increased by 12%. Advertising from Google Network Members’ websites (11% of ad revenue) fell by 2%. The group separates out YouTube, which accounted for 14% of ad revenue in the quarter and grew by 12%.

Other sales within the Services division (known as Google Subscriptions, Platforms, and Devices) include Play, content products, hardware, service, licensing fees, Nest, and YouTube’s non-advertising revenue. They grew by 28% in the quarter to $10.7bn.

Traffic acquisition costs (TAC) are the fees Google pays to other companies (such as Apple) to carry its search service and adverts (i.e., cost of sales). During Q3 they grew by 9% and currently account for 20.8% of advertising revenue.

Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Fee revenue comes from Google Cloud Platform services and Google Workspace collaboration tools. In Q3, Cloud grew by 35% to $11.4bn. This was ahead of the market expectation and an acceleration versus the 29% growth in the previous quarter. Growth was led by Google Cloud Platform across AI Infrastructure, Generative AI Solutions, and core GCP products. Although the group continues to invest to grow the cloud business, the division’s quarterly profit grew seven-fold from $266m to $1,947m.

The group’s Other Bets division (less than 1% of revenue), which is effectively an incubator fund for new products and technologies, made a quarterly loss of $1,116m, slightly below last year. The group continues to wind down non-priority projects.

Alphabet continues to ‘durably engineer’ its cost base to support its investment in long-term growth opportunities, most importantly AI. The number of employees held fairly steady at 181k, while actions are being taken to optimise global office space and use AI to increase business productivity. On the call, the company highlighted that 25% of new code is being written by AI.

In the latest quarter, ongoing efforts to improve efficiency helped deliver improved margins from 27.8% to 32.3% as costs and expenses increased at a slower rate than revenue (+8%). EPS grew by 37% in the quarter to $2.12, 6% above the consensus forecast of $2.00.

As expected, capital expenditure rose rapidly, from $8.1bn to $13.1bn in the quarter, as the company continued to pour money into AI products including enhancements to its Gemini chatbot. There is some concern across the industry regarding the level of spend on AI and the potential return on investment, although this quarter’s results provide some comfort.

Free cash flow generation was strong ($17.6bn in the quarter), despite ongoing spend on R&D and capex, while its huge cash pile (including marketable securities and long-term debt) stands at $81bn. This has allowed the group to significantly increase its returns to shareholders. During the latest quarter, the company bought back $15bn of its shares.

Back in April, the group also approved the initiation of a cash dividend programme and declared a dividend of $0.20 per share that was paid in December. Looking forward, the company intends to pay quarterly cash dividends. This is positive news and puts the company on an equal footing with Microsoft and Apple in the minds of investors looking for yield.

AI remains a hot topic. We believe the Alphabet is well placed – the company has been incorporating AI functionality into its search capabilities and other products for years and is expected to launch a steady stream of innovation in the future. Furthermore, Google’s position in cloud services – it is one of the big three public providers – leaves it well placed to provide the infrastructure and computing power needed by AI, while the group’s user scale and usage frequency supports a wealth of data, providing another competitive advantage. However, the introduction of Gemini, the group’s most advanced AI model, which is capable of more sophisticated reasoning and understanding information with a greater degree of nuance than its prior technology, has faced some issues. This has raised concerns regarding execution and company’s ability to compete in an area of technology that Google itself pioneered. Once again, this quarter’s results provide some comfort.

Looking forward, although the regulatory outlook will remain a headwind in the near term, the shares continue to trade on a valuation (17x ex-cash) below most of the other tech majors and at a level we believe is very attractive for a company exposed to several areas of long-term secular growth.

Source: Bloomberg

Yesterday evening, Visa released results for the three months to 30 September 2024, the final quarter of its FY2024 financial year. The figures were slightly better than expected driven by resilient consumer spending and strong momentum across new flows and value-added services. The company also initiated guidance for FY2025, targetting earnings growth at the high end of low double digits. The shares were marked up by 2% in after-hours trading post the announcement.

Visa is the world’s largest electronic payments network. It connects 14,500 financial institutions, 130m merchant locations, and 4.6bn cards. Visa is not a bank; it doesn’t lend or take on credit risk. It doesn’t issue cards or place the terminals at the merchant locations. Instead, the company earns a small fee from more than 230bn transactions processed on its network to generate annual revenue of more than $36bn.

The company is benefiting from the ongoing shift from cash and cheques (which still amounts to c. $18tn, growing at 2% p.a.) to electronic means of payment, and the growth of online retail, contactless, and mobile payment systems. In emerging markets, a lack of physical communication infrastructure traditionally provided a barrier to payments growth, but that has been removed by the emergence of mobile phone technology and a government focus on digitalising cash to reduce the black economy.

We believe the industry is at an inflection point in terms of sales growth driven by the global proliferation of smart devices which provide a way to pay and to be paid. In 2023, the company grew its acceptance locations by 17% as mobile phones and other devices became payment terminals.

During the latest quarter, Visa enjoyed solid trading with its key business drivers relatively stable as consumer spending remained largely resilient despite elevated interest rates. This generated growth in payments volume (+8% in constant currency) and processed transactions (+10% to 61.5bn). Cross-border volume growth (which includes a lot of e-commerce) remained strong (+13%).

Growth in ‘new flows’ has been robust and is expected to outpace the consumer payments business over the long term. The company believes the total addressable market of the opportunity is massive – $145tn in B2B payments and $55tn in disbursements/payouts/P2P. Even though yields for new flows are lower than the consumer business, on average, the business utilises Visa’s existing infrastructure and takes advantage of the company’s massive scale and fixed operating costs, resulting in higher margins.

The group’s third growth engine is value added services — services that help its clients and partners optimise their performance, differentiate their offerings and create better experiences for their customers. Visa’s largest 265 clients now use an average of more than 20 of value-added services, such as cybersecurity, fraud, data analytics, and AI, all of which enhance the group’s competitive advantage.

Net revenue grew by 12% on a constant currency basis in the quarter to $9.6bn, a touch above the market expectation and in line with the company guidance for low double-digit growth. Revenue was made up of service revenue (based on prior-quarters payment volume, +8% to $4.2bn); data processing (+8% to $4.6bn); international transaction revenue (+9% to $3.5bn); and other revenue (+30% to $969m). Client incentives, a contra-revenue item, were up 6% to $3.6bn.

For the full year, revenue grew by 10% to $35.9bn, versus guidance for low double-digit growth on a constant dollar basis.

The group continued to keep a tight rein on costs – operating expenses were up 11% in the final quarter, primarily driven by increases in marketing and personnel expenses. Adjusted EPS was up 16% on a constant currency basis, to $2.71, above the market expectation of $2.58 and company guidance for the high end of low double-digit EPS growth. Full-year EPS rose by 15% to $10.05, better than the company guidance for low teens growth.

During the quarter, Visa generated $6.4bn of free cash flow. The group’s balance sheet remains strong, with cash, cash equivalents, and available-for-sale investment securities of $17.7bn at the end of September. The main capital allocation priority is to invest to grow the business, both organically and via acquisition.

In September, the group announced the acquisition of Featurespace, a developer of real-time AI payments protection technology that prevents and mitigates payments fraud and financial crime risks. The company will complement and strengthen Visa’s portfolio of fraud detection and risk-scoring solutions used by clients around the world to grow and protect their businesses.

Visa also has an ongoing commitment to return excess cash to shareholders. The group has a record of strong dividend growth, with the latest quarterly payout raised by 13% to $0.59. During the quarter, the company also bought back $5.8bn of its stock, leaving $13.1bn of remaining authorisation for shares repurchases.

On the regulatory front, the backdrop has recently become more uncertain. In September, the US Department of Justice (DOJ) filed a lawsuit accusing Visa of violating antitrust law by suppressing competition in debit card processing by threatening merchants with high fees and paying off potential rivals. Visa will fight the claims, which it calls meritless. Although the company is likely to be forced to alter some of its business practices, we believe its strong (secure and reliable) network will help it to defend its 60%+ market share. We also believe that in the absence of a settlement, it is likely to take several years for the decision/appeal process to reach a conclusion. Visa has a long-term track record of coping with regulatory challenges and has flexibility in its cost base to mitigate any bottom-line impact.

Overall, we believe the long-term growth prospects for Visa remain attractive, more so given the acceleration in recent years in the shift to e-commerce, tap-to-pay, and new digital payments, and in the number of acceptance points at SMEs. In addition, the broad application of digital payments by businesses and government provides a huge market opportunity.

The group has issued guidance for the financial year to 30 September 2025: revenue growth on a constant dollar basis is expected to be in the high single-digit to low double-digit range, driving EPS growth at the high end of low double digits. For the current quarter, the company expects to generate revenue growth in the high single digits and EPS growth in the low double digits.

In the near term, while some short-term uncertainty persists, the group remains confident in its ability to execute its strategy and expand Visa’s role at the ‘centre of money movement’. The ongoing shift to digital payments also provide a tailwind to growth, although a slowdown in overall consumer spending could be a drag on volumes. Spending across the network is very diversified, be it credit/debit, overseas/domestic, discretionary/non-discretionary spend, and low/high ticket spend.  However, the company has previously said that if we do go into a recession, Visa is now stronger in debit – the card of choice in tougher times – than it was in the 2008/09 financial crisis. The group also highlights that if there is a downturn, they have plenty of flexibility on costs and client incentives. Note that half of the group marketing spend is variable.

Source: Bloomberg