Motley Fool Hidden Gems Investing - Microsoft and Alphabet’s Cash Stacks

Episode Date: July 26, 2023

Microsoft’s cash flow is astounding, and Alphabet’s CFO moves to a pretty cool position – CIO with a big check book.     (00:13) Tim Beyers and Dylan Lewis discuss:   - Microsoft’s strong cloud business, and why the stock’s selloff on guidance is misguided - The slow roll of AI and how investors need to be patient with new tech efforts.  - Why Alphabet may have more good days ahead of it when the advertising market rebounds.  - The legacy of Alphabet CFO Ruth Porat   (16:14) Match group and Bumble have millions of paid users... but how many of those daters are sticking around for a while? Mary Long caught up with Motley Fool contributor Ryan Henderson to discuss the business of dating apps.   Companies discussed: MSFT, GOOG, GOOGL, BMBL, MTCH Host: Dylan Lewis Guests: Tim Beyers, Mary Long, Ryan Henderson Engineers: Tim Sparks, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. Dylan Lewis. We've got the scoop on big tech's single-digit growth. Motley Fool Money starts now. I'm Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst Tim Byers. Tim, thanks for joining me. Tim Byers. Thanks, Dylan. Fully caffeinated, ready to go. I'm excited that you're caffeinated. We're going to need that caffeine. We have big tech earnings, that means some big reactions. We're going all in on the big companies today because we have results from Microsoft and Alphabet kicking off the run of the tech giants, given their updates. Tim, that means we're talking cloud, we're going to talk AI, maybe talk a little bit

about some leadership changes at these big tech companies? So, you're saying we're playing buzzword bingo, is what you're telling me? We have to. Yeah, get out your cards, listeners. It's one of those episodes. Tim, why don't we talk a little bit about Microsoft to kick things off? We have earnings and revenue ahead of expectations for the quarter. Top line grew at 8%, stocks down about 5% since reporting. What's going on there? Well, the revenue outlook was disappointing, and I put disappointing in air quotes that nobody can see because we're on a podcast. But essentially, Microsoft reported that their

next quarter will come in around $54.3 billion in revenue, and the street was saying, wait a minute, we need $55 billion, so you're $700 million short. That's problematic. The other piece of this, Dylan, is that, to, again, play the buzzword bingo card here, Microsoft is going to make bigger investments on the capital expenditure line for AI. They're going to bulk up their Azure capabilities for serving AI use cases. And yeah, that's going to require some investment in hardware, in building out their data centers. And that's not something that investors typically like to see. They want to see more cash coming through the door and less going out the door.

And so, Microsoft is signaling more is going to go out the door, and the market is responding to that. I think we can talk about whether or not that's a rational response. Yeah, I was going to say, the look back for this business, when you look at the quarterly earnings update, really strong, over $56 billion in revenue. Growth has been below 10% for the last couple of quarters, Tim, but I think that's the adjustment that we've had to get used to, but I think that's also where we've been for the last few quarters. I don't know that we can be too surprised by that. I don't think you can be at all. I think you need to take a moment to appreciate the fact that

Microsoft does complete its fiscal year during the summer. This is the end of the fiscal year. When we look back on it, to your point, Dylan, you're looking at $211.9 billion with a B during that fiscal year. That's a huge amount of money. Let's make a point here on if you are going to knock Microsoft for its spending, can we at least appreciate that this is a company that just by my estimate, Dylan, came in at about $85 billion in free cash flow in the last fiscal year. That's before you take away, let's say, any of the stock-based compensation. If you decide to cut that number by, say, $10 billion for giving equity to employees, you're still at $75 billion. So, on balance, Microsoft is somewhere between a 30% and 40% free cash flow margin.

I think they've got some money to spend, Dylan. I think they've got plenty. I think they can afford those investments, Dylan. I agree with you. One of the big sources of that investment cash over the last couple of years has been their cloud segment. This is a spot that Microsoft has, at times, been a bit cagey about the size of, especially when we zoom in specifically on the Azure segment. Looking at comments from management, we got a little bit of an update here. Azure accounting for more than 50% of Microsoft's $110 billion in annual cloud revenue. That is impressive, Tim. It's very impressive. They have a segment called Intelligent Cloud, so that is not all Azure.

It wraps in a lot of things. You don't want to get too excited about Azure when you talk about the intelligent cloud results. Having said that, you are right. Azure is growing by some pretty big numbers here. Overall, in the quarter, after you adjust for foreign exchange, it was up 27% year over year. 27%, I should say. That's a very big number. It's a segment of the business that continues to grow, and it will be fueled by this idea that we will have AI workloads that are run in the cloud, and they're largely run on Microsoft data centers that are backed by Microsoft Azure. This is a big piece of the business. It's going to continue to be a big piece of the business. No one should be surprised if

that ratio keeps moving higher here, because it's just the biggest opportunity right now. Anything that is cloud at Microsoft is really focused on enterprise, which means big in data centers, big workloads, big jobs that require big computers and a lot of storage. This is going to be a bigger segment, Dylan. I applaud Microsoft for investing in it. Yeah. I know that some people have been disappointed a little bit with the deceleration we've seen in cloud revenue, but I do think it's worth reminding people, 27% year-over-year growth rate, that's a triple, that's a double in three years. We need to keep those proportions in mind. This is going to be a much larger segment, even at some of these reduced growth

rates that we're seeing. No doubt. No doubt. I wouldn't be too surprised, but I wouldn't bet on it, if I were an investor, if we see that segment start to re-accelerate over the next 18 to 24 months just because of the demand on the AI side of the equation. Long-term, I think you could model for somewhere between 15% to 20% growth for several years. There's probably going to be a bump, maybe a little bit of acceleration before it levels off again, and that's fine. We can expect it to be volatile. But to your point, Dylan, this is a durable piece of the business and it would really be malpractice if Microsoft wasn't investing in it. Again, I'll just say,

somewhere between a 30% and 40% free cash flow margin, if you're not excited about that, I don't think I can help you. Tim, you mentioned AI, so I'm going to take the bait here. We can't talk about tech earnings and Microsoft earnings without hitting the topic. It seems like, from the market's perspective, there's a little bit of hurry up and wait with AI and the way that we're digesting these results. Generative AI has come in in such a visible way for so many people that I think it's pushed expectations a little bit. The reality is, this is a space that people are going to be investing in heavily and it's going to be hard for things to materialize for a while. It seems like that's what we

got from Microsoft in the commentary. Is anyone actually surprised by that? That shouldn't be a surprise. The history of tech is very clear. Everything that becomes an overnight sensation had 10 to 20 years in the making. That's what's happening here as well. Just because there is a lot of pent-up demand and we're going to run a lot of algorithms, there's so much work to do, particularly in software, to figure out how to optimize AI. It's not really a massive hardware problem. There will be some serious hardware investment, there's no doubt. There's going to be a lot of investment in leveraging clouds like Azure in order to bring compute power to bear on big AI problems. But there's going to be even

more investment, Dylan, in figuring out how to structure datasets, make them more interesting, invest a lot in software, create a lot of tools to make AI more functional over time. This is a multi-year process that's underway right now. So, yeah, hurry up and wait. It's a good way to put it. One company that might have a thing or two to say about AI, Tim, is Alphabet. The company also reported, got some results from them, posting revenue and earnings ahead of expectations. A similar story to Microsoft. Top line grew 7% year over year. But, different outcome. Shares up 6% today as the market's digesting these results, Tim. They had a good forecast.

Like Microsoft, in the present quarter, they beat results. But there's some positives in looking ahead here. One of the positives, you can see how Alphabet in the coming quarters is going to be a lot more profitable, Dylan. Here's the number to pay attention to, $2 billion. $2 billion in one-time costs that are being absorbed right now in other bets and other part of ... Basically, it's corporate restructuring. They did a lot of layoffs. It's pretty heartbreaking the number of people they let go and just massive cost cuts. They absorbed that $2 billion hit. Once you factor that out in future quarters, you're going to see a much more profitable alphabet overall, but right now, it's still generating 29% operating margins. Just think

about that for a second, and then apply what we're going to see in the future here. This is a business that's getting healthier. I'm not too surprised, Dylan, that an investor can look at this and say, wow, okay, this business is going to be better. I think I want a piece of that. We've been waiting for this, honestly. We've been waiting for a more efficient Alphabet. Here we go. It's coming. I think one of the other reasons you have to look at the results from Alphabet and be encouraged is, this is all happening with 3% year-over-year growth for their advertising business, which we know is just not going to be the status quo.

It's been the case for the last couple of quarters, but I have to imagine, as we get into a situation where companies are a little bit more comfortable spending on marketing and we hit that holiday season, that number is going to start climbing a little bit. You wouldn't expect YouTube to have another quarter of a year, over a year, 4% revenue growth. That seems unlikely, that we're going to see a lot of that, particularly, like you said, heading into the holiday season. I would agree with you. Despite some of those headwinds in the advertising business, this is another company, Alphabet generating about $21.5 billion in free cash flow for the quarter, about $15 billion if you take out the stock-based

compensation. Not quite as cash generative as Microsoft is, but on a run rate of, depending upon how you calculate free cash flow, somewhere between $60 and $80 billion. Again, that's a lot of money for a company that has well over $100 billion on the balance sheet right now. You mentioned their focus on efficiency. When I think of efficiency in Alphabet, I generally think of one person, and that is Ruth Porat, the company's CFO. With the earnings update, Tim, we found out that she'll be leaving the CFO role to become President and Chief Investment Officer. How are you processing that news? I mean, Porat went out for Ruth in one sense, because she's been CFO since May 2015,

So, has overseen one of the most impressive tech stories of the last 50 years. I mean, it really is incredible what Google and Alphabet has achieved during that time. I think, but the other thing that's interesting to me is, I mean, how'd you like to have $118 billion to play with and be the chief investment officer? I mean, that sounds pretty good. Sounds like a fun job. That sounds like a fun job. So, there is a lot to do. I mean, for as much as I celebrate Ruth Porat, here's where the hot take comes in.

For all of that money, Alphabet has probably been one of the worst in terms of putting just excess capital to work in a way that has been transformative for the business. I mean, I am an Alphabet shareholder. I've been an Alphabet shareholder for years. But, Dylan, I can't tell you how long it's been that Google has had over $100 billion on their balance sheet. They've invested in other bets. They've invested in some things. But have they really transformed the business in a way, like with all of that money, what could they have done that would really transform the business? Now, they've built Google Cloud, and Google Cloud is getting better, and it is getting

more profitable. But I think this has probably been one of the most capital-intensive but also wasteful businesses over those years. It'll be really interesting to me, what does she do now? Does she make other bets a lot more efficient? Do we make more strategic investments in other bets. One of the other things they said during the call here, or I guess I should say in the press release, Dylan, is that there are opportunities to be just thinking broadly about, where can Alphabet invest in markets in which are under-invested right now? What can they do with money in that way? I'm hopeful that what this means is that a company that has generally been inefficient with having transformative amounts

of money, but not really efficiently deploying that money, maybe they'll get there and do some things that are just incredible. We just are yet to see what they'll be. Tim, I want to ask you one thing before we wrap up. We look at these big tech companies as an indicator of what's going on in their industries. The narrative in this space for most of the year has been cost-cutting, efficiency, and then what can we do to hang our hat on something AI-related. Do you see those trends being the dominant things that people are paying attention to this earnings season, or do you see anything else emerging? I have said on Motley Fool Live and the show that I do with Tim White, we've been

talking on This Week in Tech about this idea that there will be a bigger emphasis on data and big data sets, and that there's probably going to be some gravitational pull towards companies that actually are attracting highly useful, highly valuable data, and that that'll be an indicator of value. I think we're going to see more of that. You'll see more companies doing that. But for the most part, yeah, I think it's going to be the themes that you're talking about. For the record, Tim, I think focusing on large datasets is a way to say AI without saying AI. I think you're probably right. Mark it on the bingo cards, listeners.

Tim Beyers, thanks so much for joining me today! Thanks, Dylan! Tim mentioned Motley Fool Live. A reminder that Motley Fool Live is our premium daily live stream. You can catch Tim Byers and our colleague Tim White talking tech Friday at 10 a.m. Eastern at live.fool.com if you're a Motley Fool premium member. We've got more Motley Fool money ahead. Match Group and Bumble have millions of paid users, but how many of those daters are sticking around for a long time? Mary Long cut up with Motley Fool contributor Ryan Henderson to discuss the business of dating apps. What does it cost to run a dating app?

does the industry see pretty wide margins? Depends on the size. The biggest costs are engineering talent, really. If you think about trying to start it yourself or something like that, you're going to pay upfront to develop the app. That's a big fixed cost. Then you're going to have to market it. There's a lot of marketing that needs to be done in the early days. If you go back and look at the history of Tinder and Bumble, Hinge grew a little more organically. But if you look at those, they were going out to college campuses and they were doing boots on the ground marketing, like, get on this app. College campuses are this ideal place for it because it's its own niche geography. You can hyper-localize. But those are the two big costs.

Then as you scale, the incremental costs or the variable costs to signing up a user are tiny. You pay app store fees. You probably pay the payments processors, so MasterCard and Visa. but really, there's not a lot of cost. Tinder reportedly has, and Tinder is the largest one in the world, reportedly has 50% operating margins. It's a very profitable business when you get to that level because like a social media, it tends to have a network effect where if you're single and you're a dater, you want to be on the platform where there's other daters. You don't want to be on this one where you're waiting to find just an account for a week or something. You want to filter through as much possible potential dates as possible.

So the platform really starts to sell itself. And you see that in some of the numbers. So for Match Group's case, in 2014, sales and marketing accounted for 38% of their revenue. Today, it accounts for 17%. And the app's much bigger, both Tinder and Hinge. And they're really pouring a lot of money still into marketing. So yes, as these apps get big, they get really profitable, but you have to climb that wall of scale first. There's only, I think, a few apps that can really say that they're at that threshold where the platform sells itself. I think it's Tinder, Bumble, and Hinge, depending on the geography. There's others, but those are the big ones here in the U.S. You mentioned the importance of the network effect when it comes

to a dating app. When it comes to competition, the story of Bumble looks like the story of David versus Goliath because Match Group is huge and owns Tinder, the biggest dating app in the world. Comparatively, Bumble's market cap is quite small. Does Bumble have to overtake Match Group in order to be a success? I don't think so. I think the pie is growing. They have. I believe they've eaten some share in terms of the market overall, but I think the pie is growing enough that it's not a winner-take-all scenario. There could be a lot winners here. To give some numbers on it, there was a study done, I think, by Stanford Business School. It showed throughout the decades, and anyone that's familiar with online dating might

have seen this chart before, around 2007, 2008, 20% of heterosexual couples in the United States met online. Ten years later, that number jumped to 40%. A lot of the respondents, I'm willing to bet were lying. The ones that said they met in a bar, they met in a restaurant. Sure, that's when they first physically met, but I'm sure they met online. It's even more popular in same-sex relationships. It's climbing and climbing here in the U.S., and then in more less developed markets, it's more stigmatized. I think in the U.S. at this point, there isn't that much of a stigma around it, but in other markets, it really is still there. And so I think as that comes down, there's a lot of room to grow internationally and Bumble's

doing that. And they have good counter-positioning, I think, against Tinder because they brand themselves as the safe platform, very women-centric, women message first. And so that's how they brand themselves. And I think it works well for them. And I think they have plenty of room to grow users. And if you just look at the last five years, Hinge, Bumble and Tinder have all grown steadily and their market shares have been relatively flat. I think Bumble's eaten share a little bit and Hinge has too, but Tinder's the elephant in the room. It's got a lot of users to shed, I guess. When it comes to Bumble specifically, what is the growth story or the growth strategy? Is it to expand internationally, to acquire smaller

startup dating apps, or to just keep eating into the market share of the Goliaths that we've mentioned. You know, reinvesting back into the business, the Bumble platform specifically is probably where they're getting the most attractive returns and just like, you know, probably app store marketing, that kind of thing. At this point, the marketing is probably limited in terms of what they need to do because so many people are already used to the platform. A lot of it is international growth. They are one of the top apps in a lot of European markets, but I worry that they... I don't necessarily want to see them try to become a house of brands like what Match Group has done because they've done that now with Badoo, which ended up being a pretty

poor acquisition looking back on it. I think part of that was maybe for the diversification part. And it's losing its thrill, I think, in its most dominant market. So they don't have great acquisition history so far. Fruits, they acquired fruits, I want to say like a year ago, it was tiny acquisition. It's really more of like a concept than a business at this point and it's really only popular in france maybe they can specific yeah and it's it's just like it's really kind of gimmicky like the app doesn't work that well so maybe they can you know throw their back end on it and kind of have better tech and you know better resources but i think ultimately the best thing they can do is brand yourself as the safe platform really focus

on kind of user verification and making sure that you're treating your users well because that's where Tinder has lost some share in being this not-so-safe platform. It's really branded that way. And then they've got other avenues like Bumble BFF, where they've kind of... I don't know if it'll necessarily move the needle financially, but it's a way to kind of be a differentiator in what's an otherwise pretty commoditized market. Yeah. And even if someone isn't paying for Bumble BFF, if Bumble can win over that user and then get them to use the dating app and monetize them. That way, I can see that to being a fruitful path. So, Bumble IPO-ed just before Valentine's Day, very fittingly, in 2021, which, lest anyone has

forgotten, was still pretty peak pandemic. Since then, Bumble's share price has tumbled more than 70%. Can this company still win in a world where people are going back out into the world and maybe stepping away from their computers a little bit or their phones? Yeah, I think the answer is yes, just because the long-term trends that i kind of talked about earlier you know it's still it kind of has this weird effect too where like the more people that are dating online the harder it is to almost date a person because you get like there's this sense that there's all these online options i guess so it's like this you know back in prior to the internet maybe there would have been the clock would have started ticking a lot quicker for people and there may they wanted to get out

there and date and they felt like they had to go talk in person whereas you kind of don't get that sense anymore, I don't think, because there's the option online. And so, I think it'll continue to grow in the US, albeit not as fast as the emerging markets. And then, as I mentioned, internationally, I think there's just a huge market to go after as hopefully the stigma starts to come down. So, I think there'll be a lot of ways to win for them, plenty of room to grow. Also, I think there's pricing power in one way or another. And it's not necessarily just a pure pricing increase, but can you mix the pricing plans so that ultimately it's revenue? Can you do a five-day plan that's 15 bucks or something like that? Can you do shorter plans, higher spend,

that kind of thing? They've done a really good job of that because paying users for Bumble is up 3X since the IPO and average revenue per paying user is up just barely. That's what they're doing is they're adjusting their pricing plans so that they can get as many pairs and still get a healthy revenue from each pair. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Dylan Lewis. That's today's Motley Fool Money episode. We'll catch you tomorrow.

Thanks for watching!