Google: Sun Shining Days

Summary:

• Alphabet/Google is on a roll. Revenue and margin expansion strategies are delivering.
• Google Cloud is finally generating profits.
• The company appears positioned to regain leadership of the AI industry.
• We are increasing our Price Target to $150/share. Reiterate Buy Rating.

Investment Thesis

Alphabet Inc. (NASDAQ:GOOG) aka Google is on the mend. The cruising that incrementally crippled the business over the previous few years is gone. Management has refocused the enterprise, identified key drivers of the next leg of revenue growth and opportunities for margin expansion. With a view to rapidly scale on the objectives, GOOG is reallocating resources, financial and technical. Brain and Deep Mind have been combined, so both teams have access to greater computational resources and generated AI knowledge. Based on the turnaround strategies being implemented, we believe a dramatic rebound in GOOG’s business is imminent. We discuss the factors driving our conviction below. However, first, our opinion on the firm’s 2Q23 financial results, which were reported last week.

As a testament to the strength of the turnaround procedures being rolled out, GOOG experienced significant improvement in financial outcomes over the second quarter, on a sequential basis, and particularly compared to the previous year’s same quarter, that represented a major driver of the company’s dismal 2022 financial performance. On a sequential basis, revenues were up ~7% vs. ~2.5% over the prior quarter, with Google Services revenues growing ~5.5% vs. ~1% during 1Q23, with Search advertising and YouTube advertising revenues expanding by ~5% and ~4% relative to ~2% and ~1%, over the previous period. Similarly, compared to the first quarter, gross margins advanced ~1% to ~57%, operating margins escalated ~4% to ~29%, and profit margins expanded ~3% to ~25%. We view the solid 2Q23 financial performance as the beginning of a trend that is likely to gather momentum as recovery policies begin to more fully reflect on operations, over the next several quarters.

Now on to a discussion on GOOG’s prospects for the next two years. Our conviction that the business is likely to rebound dramatically is based on revenue and margin expansion opportunities.

Revenue Expansion Opportunities

We view advertising and Google Cloud as the drivers of the next leg of revenue growth for GOOG.

Within the advertising vertical, for the most part, Google Search and YouTube are likely to deliver the excess growth in revenues. We believe Google Search advertisement revenue is driven by three factors, consumer traffic to the website, advertisement Return On Investment (ROI), and advertiser convenience.

In regard to increasing search traffic, with a view to sustain the relevancy of Google Search in the era of generative AI, GOOG recently launched Search Generative Experience (SGE), a Google Search platform, which is in part driven by the firm’s novel PaLM 2 large language model, in pilot mode, available selectively to the general public through a sign-up process. With the shift, native Google Search will have the ability to respond in chat format to user prompts, that have no clear answers and to creative type search terms, with additional relevant typical Google Search hyperlinks following the AI driven question and answer type result, wherever appropriate, as not all user search will require generative AI driven responses.

This will reduce compute cost/query compared to compute cost/prompt associated with pure vanilla generative AI chatbots. As the platform would continue to feature advertising, SGE solves the conundrum related to monetization of generative AI chatbots. In that context, GOOG is already experimenting with additional advertisement related formats and placements within the SGE framework to monetize the incorporated generative AI features.

With respect to the firm’s generative AI chatbot Bard, given that GOOG has upgraded the service to its next generation large language model PaLM 2, which has improved translation, introduced computer programming, and incorporated Google Lens, and that the company is developing Gemini, a foundational large language model that is expected to be multi-modal and support text to image/audio/video, to next drive Bard, we are confident that Bard will ultimately outperform Chat-GPT 4 and Microsoft’s (MSFT) similar offerings.

However, considering the advent of SGE, we believe that dedicated generative AI chatbots such as Bard and Chat-GPT 4 will be rendered obsolete, particularly given the challenges related to monetization and significant compute costs/query.

In the context of increasing advertiser ROI, the factor is dependent on clicks/advertisement (CPA). CPA is driven by consumer traffic to the website and the presentation of relevant advertisements. In regard to serving the right advertisement at the right time, GOOG is deploying AI to improve the ability of its advertisement products to identify context surrounding search terms.

With respect to increasing advertiser convenience, GOOG continues to introduce additional platforms to support easier on-boarding and creation of high quality advertisements that deliver results instantly. In that regard, Performance Max is GOOG’s service that automates advertisement creation and requires minimum input from advertisers.

Net-net, based on the company’s efforts to plug gaps related to search traffic, advertisement ROI, and advertiser convenience, it appears that GOOG is highly focused on expanding Google Search related advertisement revenues. Therefore, we anticipate near-term improvement in the metric.

We anticipate similar uptrend in advertisement revenues associated with YouTube, based on the momentum in Shorts and Connected TV (CTV). In that regard, it is noteworthy that the monthly viewership of Shorts increased to 2 billion versus 150 million in 2022, and CTV was watched by 150 million Americans last year. Considering that advertisements are the primary source of monetization for YouTube, GOOG is focused on improving and increasing content by providing creators with AI driven tools and additional formats. With respect to CTV, the firm launched NFL Sunday ticket in April, with the objective of attracting viewers.

Given that statistics provided by Nielsen, TransUnion, and Ipsos MMA indicate that YouTube advertisements on an average generate considerably greater ROI for promoters than linear TV and additional online video platforms, and GOOG’s efforts to improve the service for users (higher quality content), creators (AI tools), and promoters (Pmax created advertisements appear on YouTube, along with the company’s other platforms), we believe YouTube is primed to evidence significant growth in users, and consequently higher ROI for advertisers and incremental advertisement revenues for GOOG, over upcoming quarters.

Google Cloud

We believe that the advent of the AI era is likely to reflect favorably on revenues associated with GOOG’s cloud computing business. The cloud Infrastructure as a Service (IAS) segment that the company is focused on, is positioned to expand significantly due to its suitability to provide the resources (including computing power, storage, and data processing) and scalability required to develop AI technologies. As the largest providers of IaS, Amazon’s (AMZN) AWS, MSFT’s Azure, and GOOG’s Google Cloud are likely to capture a major fraction of surplus growth related to AI.

However, given our thesis that ultimately all large IaS providers are likely to offer similar AI related services, we do not expect Google Cloud to upend the market and capture substantial additional market share. Instead, in our judgment, although, temporary small shifts in market share are possible, major changes in competitive positioning are unlikely. AWS is likely to continue to lead, followed by Azure, and then Google Cloud. Nevertheless, as the industry is likely to expand considerably, Google Cloud, as a key IaS provider, appears suitably placed to drive an additional long-term leg of growth for GOOG.

Considering that cloud computing is a high margin business, we anticipate significant earnings flow-through to the firm’s bottom-line, as Google Cloud revenue growth intensifies.

Margin Expansion Opportunities

With the objective of squeezing incremental earnings from a potentially expanding revenue base, GOOG is implementing strategies to reduce costs and tighten operations.

In regard to cutting costs, the company remains focused on reducing headcount growth by hiring laterally from within the organization, aligning current and future real estate requirements with a smaller potential employee base and remote working features, and lowering external procurement costs.

With respect to optimizing operations, the effort includes improving machine utilization, locating more efficient and scalable methods to train and serve machine learning models, and increasing productivity at data centers by redistributing workloads as well as equipment to underutilized servers and areas.

We believe the margin expansion measures being rolled out represent simple approaches to reduce expenditure. Therefore, in our assessment, higher margins, meeting and exceeding peak levels, is a foregone conclusion. We expect GOOG to continue to deliver margin improvement on a sequential and annualized basis, over upcoming periods.

Considering our thesis that GOOG’s top-line and bottom-line growth are likely to accelerate dramatically, over the next couple of years, we are increasing the annualized revenue growth to 17% from the prior 15%, and operating cash flow margin to 29% from the previous 28%, associated with our 10-year Discounted Cash Flow model. Based on the update, we arrive at a Price Target of $150/share vs. the earlier $128/share. Reiterate Buy Rating.

Bottom Line

GOOG is back. The company beat earnings two quarters in a row. Management has identified the drivers of the next leg of revenue growth and is re-engineering the cost base to align with the shift in focus to AI, and reduced headcount/office space requirements. Sergey Brin is back at the GOOG headquarters (after a hiatus of four years) working on Gemini, the firm’s next generation foundational AI model. Alphabet is humming. More prosperity appears prescient. We recommend investors Buy GOOG stock at current levels to bask in the glory likely to unfold over upcoming years.

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Analyst’s 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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