Google Stock: 4 Things That Smart Investors Should Know
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Summary:
- I am concerned about risks for Alphabet relating to Microsoft’s growing ambitions in the search advertising market and ongoing legal tussles with the DOJ.
- But I was impressed with Google’s robust financial performance during the Global Financial Crisis, and I think that its valuations have factored in downside risks to some degree.
- I downgrade my rating for Alphabet to a Hold, after reviewing the risk-reward profile for the stock.
Justin Sullivan
Elevator Pitch
My investment rating for Alphabet Inc.’s (NASDAQ:GOOGL) (NASDAQ:GOOG) stock, which is also known as Google, is a Hold.
With my prior December 19, 2022, article, I wrote about how the new OpenAI chatbot could potentially affect Alphabet. In view of recent developments, I share my thoughts on the key issues affecting Google in this latest update.
After evaluating Alphabet’s competitive pressures, regulatory headwinds, historical results and valuations, I decided to lower my rating for Google from a Buy previously to a Hold now as I think that the stock’s risk-reward profile is balanced.
Alphabet Stock Basics
Alphabet’s search engine has a global market share of 92.9% across various platforms in January 2023 according to data sourced from Statcounter. Google is even more dominant on the mobile platform, boasting a 96.5% share of global search traffic for the prior month.
The company generated the majority or 79% of its full-year fiscal 2022 top line from its core advertising business, with search ads being the key revenue contributor. Alphabet is also referred to as “the world’s largest advertising platform” by Insider Intelligence. As per Insider Intelligence data cited in a December 23, 2022 Financial Times news article, Google is the market leader for digital advertising in its home market, the US, with an estimated market share of just under 30% in 2022.
These are the basics relating to Alphabet’s shares.
What Is The Long-Term Outlook?
The long-term outlook for Alphabet as per sell-side projections appears to be decent.
Consensus numbers obtained from S&P Capital IQ point to Alphabet achieving reasonably good top line and normalized earnings per share CAGRs of +9% and +15%, respectively for the 2023-2027 period.
But there is significant uncertainty about Google’s prospects in the long run considering tougher competition and regulatory risks, which I will touch on subsequently.
What Investors Should Know About Google Stock
Investors should understand and consider a number of key items associated with Alphabet’s stock, before they think about investing in Google’s shares. The four major things are competitive pressures, regulatory headwinds, historical financial performance, and valuations, which will be discussed in greater detail in the rest of this article.
Competitive Pressures
Seeking Alpha News reported on February 7, 2023, that Microsoft (MSFT) “would integrate artificial intelligence into its Bing search engine.” Bing has a 3.0% share of the global search engine market for all platforms, and its market for the desktop platform alone is an even higher 8.9% as per Statcounter data.
MSFT has the ambition to grab a larger share of the global digital advertising market. Microsoft has previously outlined its goal of growing its advertising revenue by 100% to $20 billion in the medium term. In a recent investor call on February 7, 2023, Microsoft emphasized that “every 1 point of share gain in the search advertising market” driven by “new users and higher engagement” for Bing is equivalent to “a $2 billion revenue opportunity.”
The worst case scenario is that Google loses substantial share to Microsoft in search engine and search advertising markets. But even if Alphabet manages to maintain its leadership in search, it could come at the expenses of higher costs and lower profitability for the company based on third-party estimates.
Goldman Sachs (GS) published a research report (not publicly available) titled “Alphabet Unveils AI Initiatives” on February 8, 2023. According to GS’ analysis, Alphabet’s gross profit margin for FY 2024 might potentially take a hit of between -0.6 percentage points and -2.3 percentage points as a result of increased AI investments to counter competitive threats. Separately, a February 9, 2023 Seeking Alpha News article also cited estimates from Morgan Stanley (MS) noting that Google’s FY 2024 EBIT could decline by -6% for “every 10% of Google Search queries that add AI/natural language.”
In summary, the threat posed by Microsoft’s Bing and other AI-powered search engines is likely to be a significant drag on Alphabet’s future profitability, as the company is likely to invest in a more aggressive manner to stay competitive.
Regulatory Headwinds
As highlighted in a January 24, 2023, Seeking Alpha News article, the U.S. Justice Department or DOJ is fighting two legal cases with Alphabet relating to the company’s “control over the digital advertising market” and “monopoly in search”, respectively.
It will be tough to predict the outcomes of these lawsuits, but heightened regulatory scrutiny is definitely a negative for Google and these legal cases are expected to drag on for years.
As outlined in the preceding section, Alphabet is facing stiffer competition from existing and new rivals with recent advancements in AI. Instead of focusing all their attention on business issues, it is inevitable that Alphabet’s top management needs to divert precious time and attention towards dealing with these legal cases.
More significantly, it is reasonable to assume that Google will adopt a cautious stance with its future business moves in consideration of the ongoing legal tussle with the DOJ and potential new regulations. This means the company will be less flexible and nimble than its other competitors (especially niche players which aren’t as large as Google) which might not be bound by such regulatory constraints.
Financial Track Record
Most investors are worried that technology companies such as Alphabet will see a big drop in their respective top line and bottom line, if the economy does much worse than what the market expects.
Google’s historical financial numbers suggest that the company is reasonably defensive contrary to what others will assume.
As per financial data taken from S&P Capital IQ, Alphabet’s revenue increased by +31.3%, +8.5%, and +24.0% for FY 2008, FY 2009, and FY 2010, respectively. In terms of the bottom line, the normalized earnings per share or EPS for Alphabet expanded by +25.1%, +19.1%, and +27.5% in 2008, 2009, and 2010, respectively.
In other words, the company’s financial performance was still pretty good during the 2008-2009 Global Financial Crisis. Also, I highlighted in my earlier July 7, 2022, article that “search advertising should grab a greater share of overall digital advertising budgets at the expense of social media advertising” in the foreseeable future.
In a nutshell, I expect Alphabet’s actual revenue and earnings to be better than what investors fear even if the economy performs poorly, based on the company’s historical financial figures, and the structural growth potential of search advertising.
Valuations
Alphabet’s current valuations are not that far off their historical lows, which implies that negatives relating to competition and regulatory issues are priced in to some extent.
The stock’s current consensus forward next twelve months’ EV/EBITDA multiple of 9.8 times is +13% above its 10-year EV/EBITDA trough of 8.7 times as per S&P Capital IQ data. Alphabet also trades at 18.6 times consensus forward next twelve months’ normalized P/E now, and this is +16% higher than its 10-year historical P/E multiple low of 16.0 times.
The Bottom Line
The risk-reward for Alphabet is fair, which translates into a Hold rating for the stock. There are risks associated with competitive threats from Microsoft and the lawsuits with the DOJ. On the flip side, there are rewards linked to better-than-expected financial results in the future (judging by its historical numbers) and the potential for valuation multiple expansion (current valuations are pretty depressed based on historical multiples).
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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