‘Search’ for a good AI stock ends here

Google has solid core businesses and is well-positioned to capitalise on AI opportunity

Amidst the global frenzy for AI stocks, it is usually hard to find a solid AI play at a discount. However, when such opportunities are presented due to some misplaced pessimism around a stock, it is time to capitalise on it. The stock of Alphabet (Google) is now presenting such an opportunity.

With some recent controversies surrounding its Gemini large language model and perceived threats to its core search business from AI products/platforms of competitors, Google has been an underperformer ytd (down 3 per cent). However, trading at a modest oneyear forward PE of 18.5 times (5year average at 20.8 times), it presents an opportunity to buy one of the world’s foremost technology companies at attractive valuation levels. Investors with a 35 year perspective can buy the stock at current levels and accumulate on dips as well.

Not only does Google have solid core businesses, but also has strong potential to become a leading player in AI. The longterm commercial opportunity in AI is currently unquantifiable, but needless to say it will be huge and can drive meaningful wealth for investors.

This wealth creation prospect still remains in the realm of probability and not certainty. At the same time, the interesting thing with the stock of Google is that even assuming an overly pessimistic scenario of stable to declining core business if and when any competitor’s AI chatbot impacts Google’s core search business, and assuming zero value for its AI business prospects, 18.5 times earnings is not a very expensive price to pay.

BUSINESS

Google functions via three reporting segments — Google Services (88.7 per cent of revenue), Google Cloud (10.8 per cent) and Others .Google Services, which originally started with just Google’s search engine during the dotcom boom, today encompasses multiple products and platforms such as Android, Chrome, Gmail/drive, Google Maps and YouTube. These businesses primarily make money by delivering advertising that appears on these properties. These ads consist of both performance advertising (paid clicks that result in direct engagement of users with advertisers) and brand advertising (display ads/videos and interactive ads).

Over the years, the company has been diversifying away from advertisements as well with subscription services on platforms such as YouTube Premium, YouTube TV, NFL Sunday Ticket (sports subscription), Google

Drive, etc. Besides these, Google also makes money from sale of aps and inapp purchases in Google Play app store and sale of devices (pixel). The nonads business has been growing faster at 20 per cent growth in CY23 as against the ads revenue growing at 6 per cent. Over the medium term, this can provide a reasonable hedge to the ads business.

The other major segment is Google Cloud which generates revenue from consumptionbased fees and subscriptions for infrastructure, platforms, collaboration tools and other cloud services. Globally Google Cloud ranks third after AWS and Azure in the cloud

BUY

Alphabet Price $136.29 WHY

Concerns on AI strategy overblown

Prospects for core businesses remain good

Discounted valuation presents an opportunity infrastructure service providers. As compared to AWS’s revenue of $91 billion in 2023 (YoY growth of 13 per cent), Google Cloud generated revenue of $34.7 billion (YoY growth of 19 per cent).

The ‘Others’ or Other Bets segment that houses Google’s moonshot businesses is like a startup ecosystem within Google, where the company invests in technological research and development to attempt solving big problems. These are investments where, if successful, the payoffs can be big, but in many cases, may not yield results. Some of the businesses in this segment are Waymo (autonomous car project) and Verily (Life sciences and healthcare research project). It would be worth noting that Google’s AI business, now part of core business, was originally incubated as a moonshot business.

CONCERNS AND RISKS

When it comes to Google, there are three main concerns. The first is that among big techs two companies that many love to hate are Google and Meta Platforms. This is due to concerns (some may be warranted) about how they use our data to maximise their profits. Further, accusations that they stifle competition, given their dominance, is also another factor. The recent controversy in India where Google delisted a few apps from Play Store is an example.

Second, recent fumbles in Gemini AI, which has resulted in accusations of bias in the platform, have led to concerns that Google may be falling behind in the AI race. The bigger concern is also that Google’s core search business might be impacted by AI search engines launched by competitors.

Finally, an issue we pointed out in bl.portfolio dated March 3 (Are Big Techs getting too big?) — the increasing scale and dominance of companies like Google especially in an AI era may result in regulatory action to reduce their dominance. While right now this is in the realm of speculation, it cannot be ignored.

In our view, despite these risks, Google presents an attractive AI play for investors. For one, it is not just premature, but actually a bit absurd to make conclusions so early that Google may have fallen behind competitors in AI. Right now, the industry is at a very early stage and missteps by Google or anyone are highly probable as the business evolves.

What is key to note is Google’s extensive investments in AI built over the last decade and technological prowess that give it a good shot to become a formidable competitor in the space. Besides, it has deep financial resources to keep investing and building its capabilities. With near $100 billion of net cash on its Balance Sheet and consistent cash flow generation (estimated CY 24 operating cash flow and fee cash flow of $125 billion and $84 billion respectively), the capacity is vast to build AI capabilities.

Further, if regulation gets more stringent, it may actually turn out to be better in the long term. For example, Google has consistently traded at a discount to Big Tech peers due to two reasons — dependency on ads and concerns on regulatory action. Better regulation that ensures better visibility of the future may actually eliminate some of the discounted valuation. Regulatory clarity on how governments intend to address dominance of Big Techs in the space of AI, while it may create shortterm volatility, may work for the better in the long term.

Amidst these factors, the stock trading at reasonable multiple following decent and consistent financial performance (see table), makes the riskreward favourable.