Google Is At A Discount Due To Regulatory Confusion

Summary:

• Google’s recent underperformance is partially due to antitrust concerns, but the impact may be overestimated.
• Google’s dominance in search is likely to continue, with potential changes in the technological landscape mitigating possible high risk remedies.
• Google’s valuation is reasonable, with potential for growth in AI, Cloud, YouTube, and continued share repurchases and dividend increases.

Google or Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), has performed poorly in the past few weeks. At least some of this underperformance versus the broader market, if not much of it, is apparently due to a federal court’s ruling that that Google has acted as a monopoly and violated antitrust laws. I believe that concern regarding this issue is substantially overestimated, and that current valuation presents both a short and long-term value opportunity.

The crux of the regulatory claim against Google was that it has used expensive agreements in order to secure a position as the default search engine on smartphones and web browsers, and that these agreements are how the company has maintained a dominant position within search. In particular, Google has an agreement with Apple (AAPL) to block competing search on iOS, and also essentially controls the Android Operating System that most competing smartphones and tablets utilize.

There are some reasons to question this decision’s logic. While it is certainly true that Google has paid substantial subs to secure its position as the default search option on iPhones, it is also likely that Google would have been the default in any case. Moreover, Google’s dominant search position on personal computers continues to be the case, despite the fact that the majority of PCs use a Microsoft (MSFT) Operating System, where MSFT also offers a competitor web browser and search product.

Another reason to question the logic of this decision is that there has recently emerged a new class of search products through large language models and the AI space. While Google does offer its Gemini product, it is one of many and far from the dominant product on this new forefront of queries.

In any case, Google is likely to engage is a slow-paced appeals process that may last two years, or even longer. It may end up winning that appeal, and it could also turn out that the technological landscape undergoes significant changes within that period, and that these changes mitigate possible remedies. For example, an AI-based search competitor could take a significant market share in search, or Google could engage in self-help where it changes its model to limit the need for further changes. Of course, the most likely result in all litigation is a settlement, which could require some degree of change to business, a potential payment to satisfy fines for alleged improper acts, as well as the possibility of a divestment of certain businesses.

Google’s search dominance is likely to continue

While Google’s market share in search is unquestionably dominant in both the domestic and international markets, as well as across various device forms, it is not entirely clear that this dominance is solely due to it entering agreements like the one it did with Apple. It is most likely the case that a majority of users would opt to utilize Google if asked to choose a search engine from a list including it and competing products.

Still, it is not clear that Google would be as dominant as it has been if such choices were prompted. Oddly enough, Microsoft appears to be one of the largest potential beneficiaries of any loosening of Google’s grip on search, since its Bing product is the second most popular one, with it handling about seven percent of the domestic search market.

While Google has many large businesses, Google’s search business remains the company’s primary asset, and accounts for more than half of its revenue. Further, it is a consistent and high margin business. Google’s market dominance in search could render lower pricing for advertising within its search responses, and this would result in a lower margin business.

At the same time, the significant payments Google has made to Apple already lower margins, and the removal of it making those payments in the future should benefit profitability. Payments to Apple are substantial, amounting to approximately $20 billion per year, so the potential removal of those in the future is significant. It is not entirely clear that such changes would actually hurt Google’s total search profitability until we see to what degree its dominance might change, as well as the speed at which those changes occur.

It should also be noted that not all searches and searchers are created equal. The more information one has on the searcher will tailor the value, and it is generally the case that it will cost more to target a wealthier potential customer. This would likely mean that iPhone users are, on average, more valuable targets. Similarly, it is probable that among Android smartphones, Samsung (OTCPK:SSNLF) users are more valuable than the average. Google currently engages in a similar arrangement with Samsung, paying it billions annually too, though substantially less than Apple receives.

A break-up of Google is unlikely and a possible benefit to shareholders anyway

It is currently unclear what potential remedies, if any, may end up being implemented. Many fear this will result in the government breaking up Google. This outcome appears to be a low probability one, at least at this point in time. Such could change if it were to be found that Google is also acting in a monopolistic manner in online advertising, but this court’s decision only involved search itself. Online advertising is more fragmented. Also, it may be difficult to solely remove search and/or web browsing from Google’s suite of products without causing harm to consumers.

If Google were to be broken up, the most apparent methodology would be to attempt to spin-off of YouTube into its own entity, and possibly a similar outcome for Android. Each of these companies would be significant in size, and their valuation may actually go up when split from search. It is not uncommon for forced break-ups to result in higher valuations for the split entities than were being realized by the solitary conglomerate.

It is also reasonably likely that the government will not have a good solution for how to dismantle Google without damaging it and harming consumers. This concern makes it more probable that the eventual outcome will be restricting Google from entering costly agreements with device makers like Apple and Samsung to secure its default search position, as well as a significant penalty payment.

I believe that the government will be rather happy with a change to Google’s practice of paying for the default position plus the payment of a sizable fine, either as a penalty or settlement payment, is the most likely outcome. The government will be able to argue that it ended the monopolistic practice, and also realize a monetary gain that is likely to be substantial. While it is not clear how much such a penalty payment may be, one must consider that Google is already paying tens of billions in payments to secure itself as the default search option on Apple and Samsung devices.

Ending those payments, and the government collecting a similar sum, may end up occurring. For example, the government may be happy to secure headlines that it changes Google’s business practices, plus obtained a payout of $20-30 billion, and potentially more.

It is likely that this change will obligate device makers to present consumers with a choice when they set up their device, as well as the opportunity to change their preferred search engine from some easy to reach setting. It appears likely that if such were to occur now, that the majority of consumers will continue to use Google’s search product.

Restricting Google from making agreements and payments to secure its default search position with device makers may actually harm those device makers more than Google. This depends upon consumer selection, which is not certain or obvious, and also subject to change across time. While this may result in the loss of some market share, and potentially a significant level of the search market, the value of that percentage of the market may end up being less than the payments Google currently makes to secure its default position.

Therefore, it could result in a slightly smaller but more profitable business. If Google retains a significant enough share of search, the change could actually end up being beneficial to Google, and primarily harmful to those device makers it has previously paid to secure its position.

Google trades at a reasonable value

I believe Google’s businesses should presently be valued at closer to $200 per share, even with the looming risk stemming from current regulatory scrutiny. This valuation is not merely due to its dominance in search, but also the continued strength of YouTube, as well as continued growth from its cloud computing business. Further, it has various potential moon-shots, and most notably the self-driving car capabilities it is developing.

Google shares also recently declined to the bottom of the trading range it has been in since late last year. Google bounced off of that bottom, but subsequently stayed close to it due to the recent court decision regarding search. I believe it should slowly return to the top of this range as the market comes to understand the true level of risk this decision presents, as well as the value at risk within Google shares.

The current business has tens of billions of dollars in annual free cash flow, and started to pay a dividend earlier this year. It has the ability to substantially grow that dividend, as well as repurchase shares, and also fund new businesses if it is permitted to enter new markets.

The most probable current primary use for Google’s existing free cash flow is to fund further investments in generative AI. Such expenditures should allow it to secure a position in any developing markets, as well as guard its position in its core product of search through the leveraging of AI features into search. Similarly, AI is likely to support Google’s advertising business, by allowing it to better target customers and tailor advertising to them.

There is also good reason to presume continued strength from the Google Cloud Platform. There is likely to be a continued migration of personal and business data workloads to public clouds. Google’s cloud products offer a free personal option and a competitively priced business solution, which should result in continued growth over the next several years.

I also believe that YouTube continues to be substantially undervalued due to it being tucked within Google’s many business segments and overshadowed by search. YouTube maintains a significant share of the streaming business, and is also an easily mobilizable asset that is likely to continue to perform well for years to come.

I expect Google’s revenue or sales to grow between seven and ten percent in each of the next two years. This growth should be primarily aided by Cloud growth, where sales are likely to grow in the double digits and potentially by more than 20% annually. I also expect Search and YouTube to both continue to perform well, and likely grow revenue in the high single digits to low double digits. YouTube may benefit more-so, provided the company is able to secure better monetization of short length videos.

While increased capital expenditures are necessary in order to support competitive AI initiatives, this CapEx is supporting large-scale datacenter development that should allow for growth in highly scalable businesses whose margins will benefit from leverage as they scale.

Further, there is the strong potential for AI innovation to enhance Google’s ads ecosystem on search and YouTube, among other smaller platforms. Such a benefit would not only improve the advertiser experience, and potentially allow for higher ad pricing, but also allow Google to better measure performance.

While there are concerns looming over Google’s dominant search business, with both regulatory scrutiny and disruptive AI competition coming fort it, search is likely to remain a highly profitable business for the foreseeable future. Further, regulatory scrutiny does not merely affect Google, but rather actually chills the capacity of all big tech competitors, thereby making it difficult for many of the fiercer market participants to easily take advantage of any opening made by the regulators.

I also believe Google’s valuation should benefit from its sizable cash position of nearly $130 billion when last reported. This cash position includes some long-term securities that may gain in value due to the probable rate cut cycle that is likely to begin in the near term. Further, this cash position is likely to be fortified by Google’s strong free cash flow. If Google’s sales were to grow as presumed, and it maintains margins at or near its 2023 and 2024 average, free cash flow should be above $80 billion in both 2024 and 2025.

Given Google’s sizable cash position and its considerable free cash flow generation, coupled with an inability to enter new markets, it is likely that Google will engage in some financial engineering over the next several quarters. This is most likely to take the shape of a large additional share repurchase program, as well as an increase to the company’s dividend. Google initiated a $0.20 quarterly dividend this past April, and an increase to that rate is probable next April, if not sooner.

Risks

The most apparent risk facing Google appears to be the regulatory risk associated with its recent court loss, and the potential for a heavy-handed remedy to harm it and consumers. Such a heavy-handed outcome is no certainty, and in fact improbable, but not impossible. Nonetheless, whatever remedy occurs, it is not likely to happen in 2025 and potentially not in 2026 either. Further, concerns regarding this risk are likely overestimated, and therefore present an opportunity at this time. Nonetheless, the possibility of a significant structural change to the search market exists and may continue to harm valuation for the next several quarters and even years.

Another risk facing Google is that it invests in various unprofitable business segments that have the potential to be huge future contributors, but which may never materialize. Such businesses are not merely eaters of cash flow, but present the risk of embarrassment in the face of a competitive threat that renders the venture obsolete. The greatest such risk appears to be to its self-driving ambitions with Waymo.

Another risk is the growth of competing video platforms that may diminish YouTube’s market share in streaming. The most apparent threat appears to be on smartphones, where apps primarily servicing short form videos have been disruptive to how viewers consume content, and may result in decreased YouTube users, as well as time spent by those users.

Conclusion

Google, or Alphabet, remains a highly profitable company that is likely to experience continued growth over the next several years. Regulatory scrutiny and AI competition have resulted in recent share underperformance, but these threats are likely being overestimated. Google remains a highly profitable business that is likely to continue to grow in the AI and Cloud segments, as well as continue to benefit from YouTube, as well as its search dominance.

Google is also likely to continue to repurchase shares, and add to its recently initiated dividend, both of which should support share price. For these reasons, I believe Google shares present a reasonable value at risk here in the $160s, and are likely to be revalued higher in coming quarters.

---

Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOG 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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

---