Google: Significant Upside Potential Even With Antitrust (Rating Upgrade)

Summary:

• Alphabet’s Q1 results show strong growth in YouTube, Search, and Google Cloud, easing concerns about antitrust risks.
• The company’s diversified business model supports a buy recommendation, with potential for sustained market leadership.
• Alphabet’s AI progress, including the introduction of Gemini 1.5 Pro, and strong financial performance contribute to an attractive risk-reward scenario for investors.

Investment Thesis

I believe Alphabet’s (NASDAQ:GOOG) (NASDAQ:GOOGL) Q1 results have reframed the company’s growth potential through showing the stand-alone power of each of their business operations within YouTube, Search, and Google Cloud. The company’s stock jumped 12% following an earnings beat driven by a 15% revenue increase, which was fueled by YouTube and Google Search earnings.

Although my previous concerns about antitrust risks loomed over the company’s core business, including their search engine, integration with YouTube and being a recent laggard in AI model development—recent developments through the earnings report suggest these risks may be overestimated​​, and I now agree. I now believe Alphabet’s diversified business model pushes against a bearish outlook based on regulatory issues.

Based on my Sum of the Parts (SOTP) analysis, Alphabet’s diverse portfolio supports a buy recommendation. Their Q1 2024 performance with growth in high-potential sectors and ongoing investments in AI and cloud infrastructure, despite antitrust scrutiny, offers an attractive risk-reward scenario for potential investors as the company strives to sustain their market leadership.

Why I Am Doing Follow-Up Coverage

In February 2024, I followed up on an article I wrote on Alphabet in December where I positioned Alphabet as a strong sell due to antitrust risks and an over-reliance on its core search business that still is vulnerable to regulatory pressures and a potential disruption from AI advancements in search technologies. I believed that the antitrust cases and the implications of a possible breakup were a significant threat to the company’s revenue models, especially their advertising business dependent on Google Search.

My original analysis speculated that antitrust interventions could negatively impact the company’s business model. However, I have recently come to a different conclusion. The strengths in Alphabet’s other business units now suggest that even if regulatory pressures were to impact their search operations, the company could still sustain their growth engines. For example, in the most recent earnings call, when speaking about YouTube performance this quarter, management noted:

And on subscriptions, which are increasingly important for YouTube, we announced that in Q1, YouTube surpassed 100 million music and premium subscribers globally, including trailers. And YouTube TV now has more than 8 million paid subscribers- Q1 earnings call

Later in this same call:

YouTube, which continues to grow and lead in streaming. We announced that on average, viewers are watching over 1 billion hours of YouTube content on TVs daily.- Q1 earnings call

Incredible and consistent performance, such with YouTube above, is exactly why I am no longer concerned over these antitrust risks associated with the recent lawsuit, and confident that these entities will be able to carry their own weight.

I am also more confident in their trajectory following the introduction of their first dividend and a substantial $70 billion stock buyback plan last week.

Q1 Recap: Strong Quarter, Great AI Progress

Alphabet’s discipline in managing AI training costs while growing ad sales has eased investor concerns about their AI strategy. CEO Sundar Pichai highlighted the company’s AI focus by calling the transition as a “once-in-a-generation opportunity.” The company has rolled out AI-driven enhancements in Search, introduced AI features in digital advertising, and leveraged AI to boost cloud computing capabilities. One of the most notable innovations is the introduction of Gemini 1.5 Pro, an AI model with enhanced performance features. As stated in the Q1 2024 earnings call, Gemini’s capabilities have already shown to be impressive, including:

dramatic performance enhancements across a number of dimensions. It includes a breakthrough in long context understanding, achieving the longest context window of any large-scale foundation model yet.- Q1 earnings call

The company reported an EPS of $1.89, surpassing expectations by 25%. Total revenue for the quarter was $80.54 billion, reflecting a YoY growth of 15.41%, to beat analyst projections by $1.84 billion. This growth was driven across their major business lines, including Google Search, YouTube, and Cloud services. The company is firing on all cylinders, showing each division is succeeding on their own.

Google’s core business, search engine and digital advertising, continued to offer revenue through ads that amounted to $61.66 billion, up by 13% YoY. This was lifted by the optimization of ad delivery and the integration of AI-driven enhancements to boost ad matching and targeting efforts.

Google Cloud posted a 28% rise in revenue, reaching $9.6 billion, which was mainly primarily supported by the expanding use of AI and machine learning technologies. During the Q1 earnings call, CEO of Google, Sundar Pichai, stated that:

more than 300 customers and partners spoke about their generative AI successes with Google Cloud, including global brands like Bayer, Cintas, Mercedes Benz, Walmart, and many more. – Q1 earnings call

Here he’s emphasizing that the implementation of AI features has successfully attracted more enterprise customers with a growing demand for cloud computing services. To me, this no longer sounds like a company that is losing the AI race.

Adding onto Google’s core business success, YouTube also followed suit with revenues up 21% YoY. As mentioned in the Q1 2024 earnings call, Alphabet is helping advertisers:

…[by introducing] new ways for brands to get the most out of their Shorts ads with new lineups on YouTube Select, including sports, beauty, fashion and lifestyle and entertainment -Q1 earnings call.

By implementing these strategies for advertisers to reach their audience more efficiently, YouTube ad revenue will continue to increase, and this is really possible even if the company is broken up. Alphabet also contributed this jump in ad revenue to their AI- features which help with direct response and brand advertising and focused on the video streaming platform’s subscription services and enhanced viewer engagement.

Adding into this (and not mentioned in the call): I think that YouTube is in store to see their user base grow even more. With TikTok’s potential exit from the United States, their disenfranchised massive user base is likely to shift to alternative platforms where YouTube Shorts has already demonstrated substantial growth, reporting over 70 billion daily views​. Shorts is part of YouTube’s Partner Program, which has an established infrastructure for content distribution and monetization. It is estimated that YouTube could recapture about 25% of TikTok’s advertising revenue once the ban takes place.

Valuation

As mentioned above, all three of Alphabet’s business segments had an incredible year. In Q1 2024 revenue was valued at $70.4 billion for Google Services, Google Cloud at $9.6 billion, and Other Bets at $495 million.

Given their rival, Microsoft’s (MSFT) Q1 2024 price to sales multiple of 12.07 (much higher than their current price to sales ratio of 5.97), the Sum of the Parts (SOTP) valuation for Alphabet is $3.89 Trillion or ~87% upside. This was calculated by doing the following:

1. Taking Q1 overall revenue and annualizing it. (80.54 billion times 4 which equals $322.56 billion). This assumes no quarter-over-quarter growth for the rest of the year, which I think is conservative.

2. Multiplying the annual revenue by the price to sales multiple of their peer, Microsoft, of 12.07. I believe Microsoft trades at a much higher price to sales multiple than Google because they do not have any real antitrust risks right now and are seen as the AI leader through their OpenAI investment. I think this is still largely true, but Google is catching up much faster than I originally thought.

I now believe the company deserves a higher Price to Sales (P/S) ratio, even with considering antitrust risks. While antitrust risks remain (see my concerns from my February article) a lot of these breakup concerns are now negated. Core platforms that I thought could be disrupted (search) continue to grow at a healthy rate. I believe Gemini’s AI capabilities are now high enough quality that they can be a huge value add to Google cloud’s enterprise customers and help keep Google search as attractive.

I believe the company is well-positioned to continue their trajectory with investments in AI research, infrastructure, and product development to further integrate AI across their services. I believe that their strategy to prioritize ongoing development of new AI models and tools, combined with strategic business decisions such as stock buybacks and dividends, signal a stronger financial future for Alphabet. Many analysts raised their price targets for Google to $200 per share, which I agree with given the company’s strategic investments.

Why I Do Not Think This Is Priced In

As of right now, the current valuation for Alphabet is based on fears regarding antitrust. The current lawsuit, United States VS. Google LLC, if ruled against, Google would split up their accused monopoly over search engines. While this may seem concerning to investors, this may not be all bad. In fact, historically, rulings like this have benefitted companies. Taking a look at Standard Oil, in 1911, after being ruled as a monopoly, they were forced to split into 34 companies. Post split, the combined total valuation of the separate entities ended up being 5 times greater than the pre-split valuation of Standard Oil. Similarly, considering how successful Alphabet’s smaller entities are currently, I predict that if this case were to rule against them, their revenue would not take a hit.

Risks To Thesis

Google has long dominated the search business with 82% of worldwide search share in January 2024, down from 91% in 2018. Microsoft has been more aggressive in the last year with integrating advanced AI technologies to improve Bing’s appeal to more users and advertisers. It’s their investments in OpenAI and the ChatGPT integration represent the company’s diversified revenue streams, stemming from their operating system and Microsoft Office. I believe they will leverage this as their stronghold in the coming years.

On top of this, in an effort to create a search engine that outperforms Google, Microsoft VP Yusuf Mehdi revealed in an interview, that their company’s goal is to find information for a billion unanswered searches that Google users don’t find when doing search. The company is also trying to bring Bing from work to personal uses through their generative AI productivity app Copilot, a Bing-integrated Windows 11, and many more.

However, as I have mentioned above, I think Google is now answering these questions with a solid response. In my opinion, I believe what is becoming the easier part of the equation is building a high-quality LLM (there are now multiple GPT4 level LLMs out there such as Gemini and Llama 3 by Meta). The hard part to disrupt Google search will be indexing the whole internet, as Google has done.

Takeaway

Despite previous concerns about antitrust risks and dependency on their search business, I believe that Alphabet’s diversified business model and recent performance suggest that the ongoing risks may be overestimated. My previous “strong sell” rating is now upgraded to “buy.” Alphabet, I believe, will continue to expand their AI and cloud computing sectors that will support the company’s revenue streams and diversify risk.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in GOOG, GOOGL over 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.

Noah Cox (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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