Episode Transcript
[00:00:00] Speaker A: Welcome to Magic Markets. Here's a taste of what you'll get in this podcast episode. In Reddit's 21 years, the Internet has changed in ways that would have been impossible to predict.
[00:00:09] Speaker B: Search is not collapsing. Search revenue actually grew 12%.
[00:00:13] Speaker A: Huffman describes Google as having shifted their relationship with the rest of the Internet.
[00:00:17] Speaker B: Query growth was actually the strongest in five years, according to Alphabet's management. Google's claims are rightly being questioned, but I think the direction of travel is clear. Clear. Google is really retaining more of that user journey inside their ecosystem.
[00:00:32] Speaker A: Always remember that nothing new here on Magic Markets is financial advice. Do your own research and enjoy the show. Welcome to episode 298 of Magic Markets and I'm going to lead us straight into it with a quote from Stephen Huffman, the co founder and CEO of Reddit. Goes like this. In Reddit's 21 years, the Internet has changed in ways that would have been impossible to predict. We've gone from flip phones to smartphones to personal AI agents. He then goes on to describe Reddit as owning its own corner of the Internet. And he points out the evolution of social media from friends and families to famous people and creators. Best of all, in his words now, from status updates to the mindless scroll. Very entertaining. And of course he's not Ron, let's be honest. He also talks about how web search has evolved from a gateway to the web to becoming an AI powered destination itself. Lots of strong words here, but no lies detected either. And the problem though is that for Reddit, AI citations are completely different to search results. Using my own words now, the Internet has gone from search as a discovery tool that actually rewards creators to AI citations that just repackage creators without giving them any reward at all. And based on everything I do in Ghostmail, I've lived this firsthand. I can see it in the web traffic. I can see how people's online behavior has changed. So if I go back to Huffman's words before I bring you in here, Mo, he said Reddit however, is still a top search term in Google, so this doesn't say anything about the Internet consumers demand for Reddit. People still want Reddit, it's just Google is not sending them to Reddit the way they used to. Now why on earth are we talking about this? We haven't suddenly become a digital marketing podcast. Don't worry, Reddit is a listed company, so. So of course is Google in the format of Alphabet as the holding company.
And this Reddit commentary is rather interesting from a Company that reportedly made $60 million a year for the past couple of years so that Google would have access to its data for AI training. Was it a big whoopsie? Well, one wonders. So Mo, let me bring you in here. Search fundamental underpinning Alphabet's business. Still to this day, Huffman describes Google as having shifted their relationship with the rest of the Internet. What have you seen in the latest Alphabet results on the topic of search specifically?
[00:02:44] Speaker B: Yeah, Ghost. I mean it was a very interesting week last week, but I actually think there are two separate questions here. And I mean the first is, are people still using Google? And then the second question is, can Google earn the same economics from the new way people are searching now on usage, search is not collapsing. Search revenue actually grew 12% to 63.4 billion. And query growth was actually the strongest in five years according to Alphabet's management.
But revenue growth has slowed from 19% in the first quarter to 17% in the second quarter and now down at 12%. So that is a massive slip. And the missing link is actually AI mode, which is currently monetizing at a much lower rate than traditional search. Let's unpack that, because traditional search often starts with what is called short, high intent queries. So for example, you search for a flight or a restaurant or a product and, and Google can then put a highly relevant advert in front of you. But when it comes to AI mode, the query is actually three times longer on average. It's more conversational, it's more exploratory. And so the user may actually be researching rather than preparing to buy something. And those searches are more expensive to process and currently harder to monetize. So AI means more queries, but Google earns less from each query. And, and this is the toss up between more engagement versus better economics. These are currently at odds.
Then onto the Huffman point you raised. The old bargain was that websites created the content, Google then indexed it and sent users to those websites. AI overviews. Now, however, as you mentioned, they ingest the content, they produce an answer and that satisfies the user without necessarily sending the click or traffic to the content site. That's a fundamental change in how the Internet works. Now Google says it's not destroying web traffic and that organic clicks are stable and actually of a higher quality. But I have seen some independent research from several analysts that have found a significant drop in outbound clicks when AI overviews appear.
So Google's claims are rightly being questioned, but I think the direction of travel is clear. Google is really Retaining more of that user journey inside their ecosystem. And this calls into question the way the Internet has historically worked. It also questions the economics of the old model. Can Google monetize that engagement without undermining the content producers or publishers that supply the information, and then also the advertisers that ultimately fund the system? I think that's unclear at this stage. Now, Reddit obviously firmly in those crosshairs. I've been on Reddit a number of times. I mean, there's lots of memes, some pretty wild conversation, and Huffman actually talks about community, connection and belonging with other people. But the question is, does this business actually make money?
[00:05:34] Speaker A: Yes, it does, Mo. And of course subreddits are really a feature of the modern Internet meme culture, all the rest. And it does make money. The top line looks good after nearly 70% revenue growth last year. They generated 53% revenue growth in the latest quarter. And ad revenue is really leading the way. Here in the US it was up 51%.
Internationally it was up 68%. So how does Reddit make money? Simply, you go onto a subreddit on a topic that you're interested in and guess what? The ads are related to the topic of that Reddit discussion. It's pretty simple really.
Now the problem is that you can't generate revenue unless you have users. And if the current trend continues, then Reddit is worried the total daily active users could fall by a low double digit percentage in the next quarter.
That is quite a frightening statistic. Now, what is Reddit doing about it? Well, like many platforms, they care about engaged users rather than total users. This is very much data Internet theory land. Is anything really real on the Internet? It all sounds ridiculous until suddenly it's not. So it becomes a fight for quality rather than quantity. And that means that the company is focusing on logged in an app daily active users, as opposed to just casual browsing.
Now, the company also claims that these users contribute around 80% of Reddit's monetization, so that is where they make the bulk of their money. And importantly, these user numbers increased sequentially. So it's the drop off in casual browsing that they are highlighting here while trying to convince the market that their business is going to be okay.
However, the market is not so sure that the business is going to be okay because there was a nasty move in the share price, even though we have a $3 billion revenue business here on a trailing 12 months basis. But they are fighting for relevance in a world where search traffic has just stopped sending people to websites. So Reddit's going to do this very brave thing. They will pivot entirely to logged in users and that's a concern to the market because that's a big friction point for a generation of Internet users who are used to having as few friction points as possible. You can go online, be anonymous, see everything, comment, do whatever you want, and never have to provide personal details or create a login. It looks like that's going to change M.O. all thanks to AI.
[00:07:52] Speaker B: Yeah, Ghost. I mean, I find this move quite interesting because I've actually landed on Reddit more often in the age of AI, you know, you're having a conversation, you click through, you go through. That's my own behavior. Maybe it's different on an aggregate level and it's a big change because the friction is a risky move. It's reflected in that market reaction. As you mentioned, Reddit fell sharply in response to these numbers to these announcements. In fact, it was the combination of Reddit and Intel last week that really dominated headlines both deep in the red.
[00:08:20] Speaker A: Yeah, look, intel is a different problem, but it did tank nearly 30% on Friday. I'm really glad that I took profit on that thing earlier this year. It's a reminder of the value of the research process we go through in Magic Markets Premium. We eat our own cooking there very often in terms of the research we do and then what we choose to do with our own money. And and we would certainly invite our podcast listeners to check out that research offering for global stocks because we do think it's quite helpful. Back to Reddit though. The share price also cratered 30% on Friday. Incredible example of how a share price can deviate from reported financial metrics because of course revenue numbers were nicely up and yet look at what the share price did. Good reminder that share prices are all about future expectations. The trailing numbers can look good, but if the future expectations have been trimmed and really bad news for a share price, especially a growth stock. Now to give more context here, free cash flow nearly doubled year on year. Net income margin was 32%. This is a business that makes money and it cares about trying to be profitable as evidenced by a statistic like general and admin headcount being flat over two years. So this is not some joke company where they simply do not care about making a profit. And longtime listeners to the show are hopefully wondering at this point about the usual issue for investors in tech companies. Some something we raise all the time, which is dilution from stock based compensation. Fair play to Reddit Here they actually give guidance on this metric, specifically annual dilution of 1 to 3%. That's how they expect it to play out. And this excludes the benefit of share buybacks. Now if you take the buybacks into account, the year to date diluted share count is up just 0.1%. So share buybacks at this stage essentially offsetting stock based compensation and that's more than a number of tech companies can say. Final comment I'll make on Reddit's financials is the guidance for the next quarter they expect revenue growth of 38 to 42%. So hardly a disaster with adjusted EBITDA up by between 47% and 56%. So the core business in terms of financial metrics doing well. But they are quite rightly worried about the top of the funnel in terms of user acquisition. It's tough scenes here for a company that's moved from trading at 10 times sales to to under 6 times sales. Unfortunately, these big valuations are capable of setting up even bigger disappointments. And if we talk about valuations then Alphabet also needs a mention here. It's come off the highs earlier this year of 11 times sales now at roughly 8 times at the time of recording share price. Finally in the red year to date, which I've got to say MO is a risk we've been flagging in magic markets premium throughout. I think we've been saying the we don't really understand how Alphabet just skates through this evolution of search completely unscathed with the market cheering them along the way, while the cheering seems to have slowed down or even stopped. Right.
[00:11:07] Speaker B: Yeah, Ghost, I mean just full disclosure, I'm currently long Alphabet, not a big position, it's been kind of uncomfortable, but I like to own some of the higher quality names in tech space just for market beta. Looking at Alphabet's numbers, I mean I would say that the results were quite remarkable still. But there's also an element of discomfort that I have and let me unpack that because looking at the top line group revenue that grew 25% to nearly 128 billion. That is a massive number. Operating income grew 30%. The operating margin was just under 32%. So these are extraordinary numbers for a company of this size. Now the standout here was cloud where revenue more than doubled to 30.7 billion, while operating profit there increased from 3.6 billion to over 11 billion. So that's a massive standout. Now demand for AI infrastructure, enterprise AI and Google's own TPU systems, that's tensor processing units the demand is enormous and maybe this is the pivot of how they win in a reorientated Internet architecture. Time will tell, but total revenue still missed the very lofty market expectations. Advertising revenue missed by around 1.4 billion and adjusted earnings also disappointed. So the market looked through the headline growth and focused on the cost of achieving it, which is currently immense. Alphabet spent more than 51 billion on CapEx in the quarter and operating cash flow was only 42 billion, which leaves free cash flow negative by around $9 billion. This is a second consecutive quarter of negative free cash flow and I think the market's concerned about this across the entire tech industry. Now the uncomfortable position that Google finds itself in is that it has to spend aggressively on these models, on the chips, the data centers, because failing to compete in AI could destroy search. But that spending is now consuming the very cash that is produced by the business it's trying to defend. So it's a double edged sword if you will. I also want to unpack the cloud result. We had direct sales of TPU systems as a big growth driver. It showed strong demand for Google's tech. But selling hardware systems isn't necessarily the same quality of revenue as recurring high margin cloud software. And it also requires more inventory and capital. So pay attention to that ghost. One last very important point I want to raise is there is this allegation during the rounds that Google is broadening its ad targeting and consuming customer budgets to protect its own revenue. Now it's still just an allegation. I wouldn't consider it as fact, but it does raise a valid criticism around transparency.
Existing ad campaigns can automatically appear inside those AI overviews in AI mode we discussed. And AI max and Performance Max can then match adverts to broader, more exploratory queries. But AI mode performance is then bundled into into ordinary campaign reporting. So an advertiser can't really compare its conversion rate, the acquisition cost or lead quality against traditional search. That's the transparency issue that I think is quite relevant. There also claims that Google can spend twice an advertiser's daily budget, which is technically true. But this is where the critique lacks some rigor. Because the daily number is explicitly an average, spending can exceed it on individual days, but it is subject to a monthly cap. So I don't think this is the smoking gun. Lastly, Google also says that click through rates on sponsored product listings in AI mode are comparable with organic listings. But click through rates don't tell us whether the users actually convert or whether the advertiser makes an acceptable return. And this talks to the changing bargain we mentioned up front.
So at 8 times sales, Alphabet is cheaper than it was at 11 times, but it isn't a low risk story. I think owning the full tech stack is a strong bull argument. It is overlaid with some optionality that they eventually get AI monetization right and that it can catch up to traditional search. And in that case, yes, maybe Alphabet looks cheap, but I would say the counter is that search's currently degraded revenue could become entrenched and this means that the capex bill will be an albatross for them to bear. So maybe it's better, yes, for Google to cannibalize search before someone else does it. This is a market of disruptors. But can they find a new stable set of economics in an AI world and can they eventually see a decent ROI on all of this capex? I think that's a big question that's facing not just Google or Alphabet, it's most of big tech. And that's why in this week's Magic Markets premium we're covering Amazon, they're facing similar challenges on the capex side and subscribers can go and check that out. We've got a full bull and bear box. We've got a bottom up analysis on the latest quarter, so check it out. And if you aren't a subscriber, it's only 99 rand a month. So really we think that's great value for deep research on global stocks every single week. Ghost. I think that's where we've got to leave it this week to our listeners. Let us know what you thought of the show. Hit us up on social media. It's magicmarketspod. One word, Inde, Ghost and Mohammed Nala all on X or can find us on LinkedIn. Pop us a note on there until next week, same time, same place. Thanks and cheers.
[00:16:20] Speaker A: Ciao.
