Alphabet (GOOGL) reported weaker-than-expected earnings and sales for the first quarter on Tuesday after the bell, due to YouTube ad revenue coming up short. The headline results, however, do not tell the full story.

Consolidated results

Revenue of $68.01 billion (up 23% year over year, or a gain of 26% on a constant currency basis) came up short versus expectations of $68.14 billion while diluted earnings of $24.62 per share missed the $25.66 per share consensus. (Constant currencies help strip out fluctuations in foreign currency to provide a clearer financial picture.)

Operating income of $20.09 billion outpaced the $19.745 billion estimate, as operating margins held steady at 30%. That said, earnings took a $0.99 per share hit due to a $1.07 billion loss on equity securities recorded in other income/expense.

On the cost side, total traffic acquisition costs (TAC), came in at $11.99 billion, marginally above the $11.93 billion expected.

As for cash flow, operating cash flow came in at $25.11 billion, short versus expectations of $25.67 billion. Free cash flow came in at $15.32 billion, below the $17.8 billion expected by the Street.

While the results missed expectations, investors still benefit from the search giant’s exceptional cash flow generation, as management announced a new $70 billion share repurchase authorization of Class A and Class C shares. Assuming a market cap of roughly $1.46 trillion (based on an after-hours share price of about $2,215), this amounts to just under 5% of the market cap.

Segment results

Google advertising revenue of $54.66 billion missed the $55.03 billion consensus. 

• Google Search and other: $39.62 billion vs $39.18 billion

• YouTube ads: $6.87 billion vs. $7.45 billion

• Google Network: $8.17 billion vs. $7.96 billion

Add Google other sales of $6.811 billion, which missed the $7.36 billion consensus, to the advertising figure and we get a Google Services total of $61.47 billion, below expectations of $62.21 billion. Elsewhere, Other Bets revenue of $440 million outpaced the $206 million expected, while Google Cloud revenue of $5.82 billion came in ahead of the $5.77 billion consensus.

As for profitability, Alphabet reported operating profit of $20.09 billion, better than the $19.75 Street consensus. Segment operating profit was as follows:

• Google Services: $22.92 billion vs. $22.37 billion expected

• Google Cloud: $931 million loss vs. a $739 million loss expected

• Other Bets: $1.16 billion loss vs. $1.27 billion loss expected

• Corporate costs, unallocated: $740 million loss vs. an $846 million loss expected

We believe the greater-than-anticipated loss for Google Cloud to be acceptable given Google’s need to play catch up with Microsoft (MSFT) and Amazon(AMZN). This appears to be happening, as Google Cloud grew 44% annually. Google Cloud Platform (the direct competitor to Azure and AWS) was “again greater that Cloud’s, reflecting significant growth in both infrastructure and platform services.” Management did not break out the actual growth rate. 

Thoughts on YouTube

While we do not make light of the YouTube miss, we believe the dynamics that impacted the top-line to be temporary. For starters, similar to what we saw from Meta Platforms (FB) last quarter with Reels, the growth of YouTube Shorts as a percentage of time spent on YouTube was a headwind to growth. Shorts now averages over 30 billion views per day, a four-fold increase versus the year ago period. 

Also impacting YouTube advertising revenue was the war in Ukraine, which is having an “outsized impact on YouTube ads relative to the rest of Google.” The final revenue growth headwind noted on the call (aside from foreign exchange rates) was the ongoing impact of Apple’s app tracking transparency (ATT) updates, which continue to impact direct response advertising.

Ultimately we believe the Shorts headwind will turn into a tailwind as management fine-tunes monetization on the increased engagement. Management explained on the call with investors they are focused first and foremost on creating a great user experience for Shorts and they are “very actively working on what monetization could look like in the future.” The war in Ukraine remains source of pressure as brands cut advertising budgets in Europe, though we believe that this too will rebound in time.

At the end of the day, Alphabet provides advertisers with best-in-class returns on their advertising spend. As a result, it will continue to attract an outsized proportion of advertising budgets. Moreover, while the Apple (AAPL) app tracking update may take a toll on YouTube advertising ROIs, it still does not appear to be hitting spend on Search advertisements. That’s because users actively navigate to search to input their queries, something Apple does not take issue with.

At the end of the day, YouTube is a nearly $28 billion run-rate business (think this quarter’s revenue annualized) that has no need to spend monstrous amounts annually on new content in order to stay relevant. The platform boasts over two billion monthly signed-in users and also has 700 million hours per day of viewership on televisions. In other words, this is not a mobile-only platform and is very much a competitor in the streaming wars.

Bottom line

While Alphabet’s headline numbers missed Street expectations, we believe the results did not deserve the after-hour's nearly 6% drop, considering where shares were trading at before the print. It's not that investors & analysts were expecting a boom& bust from Google; everyone knew about tough comps, slowdowns due to Russia-Ukraine. It was only a matter of how much, but shares were already trying to price this in being down ~20% YTD.

Our core investment thesis remains firmly in tact. And at the current historically low valuation, we are willing to endure additional pain the market throws our way.