The main bear case for Alphabet (NASDAQ:GOOGL) is the prospect of share losses in its Search business to Microsoft’s Bing and OpenAI’s Chat GPT and even if its attempts at creating a rival chatbot prove effective it will be more cannibalistic than incremental.
The bears are missing the investments in AI underpinning Project Magi – Google’s counter-strategy to the threat posed by Microsoft’s Bing and Bard, Google’s chatbot innovation powered by the PaLM 2 large language model. Google has been developing AI for over two decades and in 2011 formed Google Brain, a deep learning intelligence division. The team created TensorFlow, an open-source deep learning software for training and developing deep neural networks which spurred the creation of the Tensor Processing Unit (TPU), a chip specified for deep learning.
A suite of tools – founded in machine learning, neural networks, and natural language processing – are being rolled out which will deliver more advanced AI capabilities than OpenAI. The overall effect on ad revenue will be more incremental than substitutive since AI provides a more precise, personalized experience such that even if a query is more expensive to serve, the improvement in conversion rate for the advertiser will more than compensate for the extra cost. For instance, Google will learn the size and shape of your feet to find the best-fitting shoes, your diet so it can recommend suitable supplements or where you go on vacation to notify you of travel options. Such heightened personalization should lead to more satisfied users and those showing commercial intent will be provided with more suitable ad matches.
Despite all the concerns around competition from Chat GPT, Google Search revenue grew 4.8% in the second quarter and total revenue expanded by 7.1% year-on-year. Within the core ad business, YouTube contributed 13.2% of revenue yet was accompanied by only a modest 2.6% increase in traffic acquisition costs. A key driver has been Shorts, a short-form section of the site, which earlier this year surpassed 50 billion daily views. Shorts is competing effectively against Reels on Facebook and TikTok. Shorts were originally monetized through income from YouTube Premium, which reached 80 million subscribers in 2022, but plans are underway to offer an ad component, in particular a direct response format. Despite concerns about a switch to Bing, Google has also been retained by Samsung as its default internet browser, a relationship which generates around $3bn of revenue for Alphabet.
As with other leading Big Tech peers, Alphabet has been focused on delivering efficiency gains. Expense growth and pace of hiring have slowed and teams have been consolidated where appropriate (such as the Brain Team combining with Deep Mind) with a greater focus on higher priority activities at the expense of more speculative, risky ventures. These developments, along with real estate optimization initiatives, led operating expenses to rise by only 4% compared to a 12% gain in operating income in the second quarter.
There are some promising signs of AI tool adoption. In the second quarter, Google launched the search generative experience, an AI-powered solution to make search more intuitive and powerful with more precise, granular answers to both regular and esoteric queries. There has been an intense focus on the travel vertical to ensure users have a great body of information at their disposal to facilitate booking trips and building itineraries. These engineering enhancements allow users to attain a greater depth of understanding.
Multi-Product Set
While Search is the dominant revenue driver, it is important to note Alphabet has an extensive array of products with over a billion users:
|
Alphabet Product |
User Base |
|
Google Seach |
3.6bn |
|
Android |
3.0bn |
|
Chrome |
2.7bn |
|
G-Mail |
1.8bn |
|
Google Drive |
1.0bn |
|
Google Play Store |
2.5bn |
|
YouTube |
2.1bn |
|
Google Photos |
1.0bn |
Source: 01Core Substack
Contrary to populist opinion, ads should continue to be integrated into AI-assisted search. Google has been building AI features for several years and is providing advertisers with tools that leverage Generative AI, such as Performance Max, Product Studio, and Conversational Experience which simulates human interaction using natural language models.
Google Cloud Platform (GCP) is Profitable and Growing
Cloud revenue grew by 28.0% y-o-y in Q2 to reach $8.1bn. This business became profitable for the first time in Q1 and operating income grew to $395 million in Q2, yielding an operating margin of 5%. Generative AI is driving a resurgence in the cloud computing sector. Corporations are embracing AI productivity and cloud providers are integrating AI into their services. Partnerships and AI product launches are starting to ramp and the AI as a Service Market is poised to reach $55 billion by 2028. On the recent Q2 call, management highlighted that more than 70% of GenAI unicorns are GCP customers serviced by a mix of Nvidia GPUs and Google in-house TPU chips. As consultants and engineers become trained on GCP, ‘learning effects’ start to serve as a competitive advantage. With global IT spend rising amid ongoing digital transformation initiatives as well as new cases in AI emerging in areas such as drug discovery, cyber-security, and anti-money laundering, Alphabet’s cloud computing growth potential is highly promising given the pivotal role AI plays in re-shaping the industry and enhancing business efficiency.
Addressing the ChatGPT Risk
Sceptics view OpenAI’s ChatGPT as a direct threat to Google Search. The extent to which users transition from a traditional search to a Chatbot is difficult to assess. As of now, Google Search provides users with the best access launchpad to navigate the World Wide Web. Nonetheless, management is not resting on its laurels. Bard, Google’s AI query service, launched in March 2023 and is now available in most of the world across 40 languages. Bard has several advantages over Chat GPT: 1) OpenAI’s training model has a cut-off date of September 2021 whereas Bard is up-to-date; 2) ChatGPT has a freemium model with $20 monthly subscription whereas Bard, at least currently, is free; 3) Bard is a 137bn parameter model vs ChatGPT’s 1.3bn parameters and is trained on a dataset 3x larger, which incorporates both text and code. 4) given its training on LaMDA, Bard offers a more natural, intuitive conversation; and 5) Bard has incorporated Google Lens which enhances its ability to process and contextualize images.
Attractive Valuation
Earnings per share for 2024 are set to accelerate towards $7+ driven by faster search growth and continued GDP adoption given customer interest in Generative AI offerings underpinned by well-engineered large language models. Moreover, the company has become disciplined around operating costs which should lead to some degree of margin expansion. Given the shares are trading off 5.8% in after-hours post-Q3 results, this implies a forward P/E ratio of 18.5x. Alphabet also has $106bn of net cash on the balance sheet which equates to $8 per share. Subtracting net cash lowers the forward multiple to 17.23x – an attractive valuation for a capital-light business with strong network effects which has expanded free cash flow by 20% over the last five years.
Summary
The market is underestimating the quality and durability of Google’s search engine and its connectivity to global advertisers. Google may appear to be scrambling to imitate ChatGPT but in reality, it has a long heritage in pioneering AI tools and is sensibly pacing the roll-out of these initiatives. Just as the company navigated the desktop-to-mobile transition and the use of apps vs internet browsers, it is well placed to pivot and dominate the Chatbot/Gen AI era. Through accessing your browser history on Chrome, your search history on Google, and your choice of content on YouTube, the ad targeting potential is unrivaled. Despite in-roads by Amazon and TikTok, Alphabet still captures an industry-leading 28.8% of US digital ad revenue, a level which peaked at 34.7%. Given sustained dominance in digital search advertising and the potential for a broader contribution from additional revenue streams, shares in Alphabet are recommended for purchase.
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