Google Q3 Earnings: Perplexity Is Not A Threat

Summary:

• Google’s Q3 earnings exceeded expectations with $88.27 billion in revenue, a 14.9% YoY increase, and $2.12 EPS, beating analyst projections by $0.27.
• Despite a 14% rise in shares since September, Perplexity’s growing presence has sparked concerns, though disruption risk appears minimal.
• Google’s AI generates over 25% of new code, significantly boosting innovation speed and enhancing competitiveness against emerging AI platforms.
• With a forward P/E of 21.27 and projected 24.03% YoY EPS growth, Google’s valuation appears justified given strong performance across key segments.

Co-Authored By Noah Cox and Brock Heilig.

Investment Thesis

Google (NASDAQ:GOOG) (NASDAQ:GOOGL) shares were up roughly 3% today following earnings on October 29th that both exceeded immediate analyst expectations and also helped clarify that the long run future of Google still looks bright. Yesterday’s strong quarter, coupled with a blowout performance from Google Cloud, tells me that the company is not going to get disrupted anytime soon.

In fact, I actually think it’s much of the opposite. Below the surface, the company is innovating in key ways that tell me they are getting lean and nimble again. New AI developments are telling me they are able to react far more quickly to a lot of the threats that are facing the business.

With this, I think Google shares continue to be a strong buy. I found this quarter to be highly validating.

Why I’m Doing Follow-Up Coverage

Google stock has beaten the market since I last wrote on the internet search giant in September, when the market was worried about new antitrust risks from the US DOJ.

Since then, the market has found a new worry: since September, a rumored new funding round for AI search engine Perplexity has made some investors worried. Some investors fear that the new search startup could now pose a serious challenge to Google, as the platform specializes in using AI to help users get more direct answers to their questions, which has become a major complaint of Google search over the last few years.

Although Google stock has risen nearly 14% since my last coverage in early September, the stock has fallen about 3.28% since I did an earnings preview over the summer. I think a lot of this selloff has been competition risk.

The purpose of this follow-up coverage is to show how Google still has an incredibly robust business model, and faces a low probability of being disrupted at any near point in the future. New developments from the earnings report tell me the disruption risk has actually gone down.

Q3 Review

Google’s Q3 numbers were very impressive. Q3 GAAP EPS of $2.12 beat out the analysts’ projections by $0.27.

On the revenue side, Google’s Q3 revenue of $88.27 billion outperformed analyst expectations by more than $2 billion. We’ll dive into the drivers of this revenue beat, but all around this was a solid win for the search giant.

The nearly $90 billion in quarterly revenue represented 14.9% YoY growth.

Not only was Google search itself strong during Q3, but Google Cloud Services also performed exceptionally. In the earnings call from October 29, Google CEO Sundar Pichai spoke to the success of the Cloud Services in Q3.

I’m very pleased with our growth, Pichai said.

This business has real momentum and the overall opportunity is increasing as customers embrace GenAI. We generated Q3 revenues of $11.4 billion, up 35% over last year with operating margins of 17%. Our technology leadership and AI portfolio are helping us attract new customers, win larger deals and drive 30% deeper product adoption with existing customers.

Senior Vice President and Chief Business Officer Philipp Schindler also added to the discussion of strong Q3 performance on the earnings call.

Google Services delivered revenues of $76.5 billion for the quarter, up 13% year-on-year. Search and other revenues grew 12% year-on-year, led by growth in the financial services vertical due to strength in insurance, followed by retail. YouTube ads revenues grew 12% year-on-year, driven by brand, closely followed by direct response.

The final thing I want to touch on from earnings was the AI code generation, which to me, I found to be astonishing. According to remarks from Pichai on the recent Earnings Call, more than a quarter of all of Google’s new code is generated by AI.

More than a quarter of all new code at Google is generated by AI, then reviewed and accepted by engineers. This helps our engineers do more and move faster. I’m energized by our progress and the opportunities ahead, and we continue to be laser-focused on building great products…

I find this to be a game changer because this is the holy grail of a software company (like Google). The firm is now innovating at a much faster speed thanks to the help of AI. This helps them refine search to be better (more than just keyword results) while also not running afoul of copyright laws like their competitor Perplexity is embroiled in (as I discuss below).

Google Is Not Getting Disrupted

As I mentioned before, AI startup Perplexity has risen in popularity, which has raised some alarm bells among investors that as the company continues to raise funding, their new platform will be a real risk to Google. They believe that Perplexity could deter some Google users from using the platform.

Behind this is the new way that Perplexity (and other AI startups do search). Google is a traditional keyword search engine, which means you type in a series of keywords into a search box, and the output is a collection of websites that match those specific keywords.

Perplexity, on the other hand, is a semantic search engine. This means that users type in a sentence for questions they have, and Perplexity helps answer your question and provides a handful of sources. Most search users have shown a preference for getting the answers, and less about variety. The downside of this is that platforms like Perplexity, as they develop results for users, may be plagiarizing copyrighted material. This is a big deal.

There’s a risk Perplexity could be taking copied material and repurposing it for their search results by providing responses directly from copyrighted content. In fact, just in the last two weeks Perplexity was sued by the Wall Street Journal owner, Dow Jones News because of this.

While Perplexity denies the allegations, I think this lawsuit could end up being akin to the Napster lawsuit of 2000 that bankrupted the company due to them redistributing copyrighted music.

Meanwhile, Google is not named in this lawsuit because their search engine is not used this way. Google simply redisplays search engine results rather than using whole chunks of information from other sources, like Perplexity is alleged to do.

Valuation

Some investors have been cautious about getting involved in the Google investment story because of the antitrust proceedings and the Perplexity/ChatGPT disruption risk.

Google’s forward P/E currently comes in at 21.27 which barely beats the sector median of 19.76, or a 7.65% premium to the sector median. Seeking Alpha grades this P/E at a C+.

Yet at the same time, Google’s forward EPS growth is supposed to come in at 24.03% YoY compared to the sector median GAAP EPS growth of just 9.70%. This is a 147.65% premium to the sector median EPS growth rate.

Growth is strong, and therefore I think the valuation premium makes sense. In fact, I actually think that the company should be trading at a 25% premium to the sector median price-to-earnings ratio because I think it has become increasingly clear that their growth is robust. I think they’re firing on all cylinders.

If we saw shares converge on a 25% premium to the sector median, it would mean Google would be trading at 24.1 forward P/E, which would represent a 16.12% upside for the company as a whole.

Risks

I think the biggest elephant risk in the room for Google continues to be antitrust risk, which I touched on in my intra-quarter piece. The Department of Justice is currently suing the company for violating antitrust laws for its search business. When this news broke earlier in the fall, I did a deep dive into this and found that the search business has a high probability of coming out relatively unscathed.

Regardless of the antitrust risk, I think there is increasing evidence that the company is not only able to stand as separate, standalone units, but that some of the ‘other’ bets the company has are firing on all cylinders too, increasing the sum of the parts (SOTP) fair value.

For example, Google and Google Cloud are both growing rather consistently (and if split both would still grow well separately). Now, Google is seeing a lot of this growth coming from their Waymo division. Revenue in this area (other bets) is now over $388 million.

Pichai discussed Waymo on the recent Earnings Call.

I want to highlight Waymo, the biggest part of our [other] portfolio, Pichai said.

Waymo is now a clear technical leader within the autonomous vehicle industry and creating a growing commercial opportunity. Over the years, Waymo has been infusing cutting-edge AI into its work. Now each week, Waymo is driving more than 1 million fully autonomous miles and serves over 150,000 paid rides. The first time any AV company has reached this kind of mainstream use.

Google clearly is building out a powerful business inside their umbrella company with Waymo that makes the company more than search. I’m impressed.

Bottom Line

While some investors have had their concerns, Q3 earnings continue to show that Google has what it takes to continue being the main, go-to search engine that people use. Perplexity’s rise certainly has given some analysts some hesitancy. However, I think Perplexity’s AI model and content repurposing is a bit flawed, and I don’t think it’s sustainable going forward.

Google has been the mainstay as an internet search engine for decades now, and I believe it will continue to excel as their foundation of a keyword search engine beats out semantic search, which may run afoul of copyright laws.

With this, I continue to believe that Google has strong potential both from a business standpoint and also because their valuation appears really reasonable from here. I think shares continue to be a strong buy.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOGL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Noah Cox (main account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.

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