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How is Alphabet (GOOGL) positioning its AI tools to maintain search market share and keep its advertising business growing? Are AI use cases continuing to drive growth within Google Cloud?
Capital Spending Plan Updates
There is growing concern that investments in data centers and computing power at Alphabet, Meta Platforms (META), Amazon (AMZN), and Microsoft (MSFT) will fail to deliver decent financial returns. Beyond that, we suspect people are interested in how Alphabet’s plans could affect Nvidia (NVDA).
The Status of the Advertising Market
Is demand for digital advertising at least holding steady? Cost per click in the search business was up 8% in the first quarter after being stagnant or down for 18 months. There is fear that demand from Asian retailers (like Temu) for US ads will wane and pull pricing lower.
Search Volume
If search click volumes are weak, that would feed the narrative that new AI tools from OpenAI/Microsoft and others are chipping away at Google’s dominance.
Other Issues
What’s the thinking behind the rumored Wiz acquisition? Are there any developments on an Apple partnership to include Google AI tools in the next iPhone? Are there updates on any of the lawsuits Alphabet is facing?
Key Morningstar Metrics for Alphabet
• Fair Value Estimate: $171.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High
Fair Value Estimate for Alphabet
Our Fair Value Estimate is $171 per share, equivalent to a 2024 enterprise value/EBITDA ratio of 15. We expect slight margin pressure in 2024 given the firm’s continued investments in growth initiatives, mainly in AI, which require higher research and development. We look for margin improvement in 2025-28, driven by better generative AI search monetization and faster growth in cloud, thanks to wider adoption of generative AI. Our model assumes a five-year compound annual growth rate of over 10% for total revenue and a five-year average operating margin of nearly 29%.
We expect advertising revenue to remain over 70% of Alphabet’s total revenue, driven by continuing growth in digital ad spending, albeit at a much slower rate than historically. We model 6.5% ad revenue growth for 2024 due to slower expected economic growth than in 2023. We have estimated total Google ad revenue of $253 billion in 2024 and $272 billion in 2025. We think YouTube will contribute 13.6% of Google’s advertising revenue in 2024, up slightly from 2023, and more than 14% in 2025. YouTube growth should benefit from its impressive reach and usage frequency, plus its video-only content format, which is attractive to brand advertisers.
Read more about Alphabet’s fair value estimate
Economic Moat Rating
We assign Alphabet a wide moat, thanks to durable competitive advantages derived from the company’s intangible assets, as well as its network effect.
We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and AI (machine learning and deep learning), as well as access to and accumulation of valuable data for advertisers. We also believe Google’s brand is a significant asset. “Google it” has become synonymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry. While Microsoft’s (MSFT) Bing is attempting to dethrone Google with AI technology from OpenAI, we think the firm can defend its dominance in search with its own AI technology, some of which OpenAI’s products are based on.
Read more about Alphabet’s economic moat
Financial Strength
Alphabet has a strong balance sheet, with cash and cash equivalents of $111 billion versus total debt of only $13 billion as of the end of 2023. The company also has a $4 billion revolver with no outstanding balance. Over 60% of the company’s cash and cash equivalents are held outside the United States.
Read more about Alphabet’s financial strength
Risk and Uncertainty
Our Uncertainty Rating for Alphabet is High. While we remain confident that Google will maintain its dominant position in the search market, a long-lasting downturn in online ad spending could harm the firm’s revenue and cash flow. On the other hand, positive returns on Alphabet’s investments in cloud and moonshots could considerably increase our fair value estimate.
Google faces antitrust pressure and various claims and investigations from different regulatory agencies regarding search bias and its overall market dominance in online advertising. Some governments may forbid access to some of Google’s properties, which could result in lower user growth and monetisation. Similarly to Meta, Google faces limitations on mergers and acquisitions as the US and other countries attempt to lessen the firm’s dominance in advertising and the internet market.
Read more about Alphabet’s risk and uncertainty
Alphabet Bulls Say
As the number of online users and usage increase, so will digital ad spending, of which Google will remain one of the main beneficiaries.
Android’s dominant global market share of smartphones leaves Google well-positioned to continue dominating mobile search.
The significant cash generated by the Google search business allows Alphabet to focus on innovation and long-term growth opportunities in new areas.
Alphabet Bears Say
There is little revenue diversification within Alphabet, as it remains heavily dependent on Google and search advertising.
Alphabet is allocating too much capital toward high-risk bets, which face a very low probability of generating returns.
Google’s dominant position in online search is not durable, as more companies and regulatory agencies are contesting the methods through which the company has been extending its leadership.
This article was compiled by Krutang Desai
