Growth Stocks: Alphabet Inc. (Google)

Alphabet Inc. (GOOGL.US), will publish its second quarter results for the period ended June 30, 2023, after the market close on Tuesday, July 25. Market analysts project the company's earnings per share (EPS) to be $1.34, accompanied by a revenue figure of $72.750 million. Meeting these projections means a notable increase of 10.74% in EPS and a 4.40% increase in revenue compared to the results of the previous year.

Sectoral contextualization of AI

This last quarter has been a bombshell with news and headlines around ChatGPT and this growing interest in artificial intelligence might seem like a sudden phenomenon, but the truth is that AI has been in development as we know it today for almost a decade. But its origins are even further away.

Take, for example, the Turing Test, which was introduced almost 75 years ago in 1950 as a measure of a machine's ability to exhibit human-like intelligence. It's been 25 years since IBM's Deep Blue computer defeated world chess champion Garry Kasparov, and more than seven years since Sundar Pichai became Google's CEO and declared the company's focus on AI.

Artificial intelligence is already a significant part of our daily lives. From the AI software layers that optimize routes in navigation tools like Google Maps to facial recognition on our phones, AI is here. AI tools are also used, with varying degrees of success, to monitor social networks and identify problematic posts that violate the terms of service.

So why is AI suddenly in the news?

The focus is on the introduction of natural language AI interfaces, especially those defined as “Large Language Models”, which allow non-technical people to interact directly with AI programs. ChatGPT was not the first of its kind, but it was the first publicly available chat-based AI interface to achieve widespread popularity.

In the summer of 2022, Google's LaMDA (AI) received buzz from the mainstream press when an engineer claimed that he had become conscious, but was not available to the public. Facebook's (META.US) BlenderBot 3 ran into problems with misinformation and conspiracy theories when it was released to the public, leading to its early removal.

source: google

Even ChatGPT had some disturbing incidents during its initial release for Microsoft Bing. The chatbot, named Sydney, acted erratically before its parameters were adjusted to improve its behavior.

Despite these challenges, AI chatbots like OpenAI's ChatGPT and Google's Bard are now available to the public after necessary modifications. This development can be compared to the "Mosaic Moment" in the artificial intelligence industry. Mosaic, the first popular graphical web browser released in 1993, made the Internet accessible to non-technical users through its easy-to-use interface. Similarly, the AI industry is experiencing a similar breakthrough today, making AI more accessible to the general public.

As potential Google investors, a crucial question for us to address is whether the rise of chat-based AI interfaces poses a threat to the company's profitable Search business. Some investors are concerned that Google is lagging behind in AI, leaving room for competitors with more advanced AI capabilities to overtake them. However, the idea that Google is lagging behind in AI is wrong and we will see why below.

The new AI is based on AI previously developed by Google

ChatGPT and other chat-based AI models are built on transformers, a neural network architecture developed by (surprise) Google in 2017. This is not surprising, as Google has been a leading AI research organization for a long time, and AI is already embedded in almost every service they offer. Although they may not have been the first to launch a publicly accessible chatbot, they developed their own chatbot over a year ago, which displayed impressive capabilities that led experienced AI researchers to believe it had reached a level of awareness.

Thanks to Google's “Big Data” approach to AI, they were able to quickly respond to the launches of Microsoft chatbots and OpenAI with their own proposals. Importantly, Google not only launched Bard, but also integrated chat-based responses directly into Google's native search results, something Microsoft Bing has yet to do with its search engine.

In addition, Google has introduced several other AI programs. For example, Gmail is getting an AI program that composes emails, and its suite of productivity software like spreadsheets and word processors will use AI tools to help create content. Most importantly, Google is expanding its AI-powered Performance Max program, automating advertisers' ad campaigns and incorporating generative AI programs to write ads and create ad assets.

Risks?

Despite these advances, there have been concerns that the rise of AI could pose risks to Google. When there is a platform change, the incumbent leaders (original creators) of legacy platforms are often vulnerable. This is reminiscent of the shift from desktop internet access to mobile internet, which was perceived as a threat to Google's success. However, Google's business and stock have prospered since then, proving that platform changes don't always hurt incumbents, especially when they drive the change themselves.

For direct non-purchase information requests, such as "what is the capital of California?", both ChatGPT and Google Bard provide the same answer as a traditional Google search: Sacramento. These "zero-click" searches, where users get the answer without visiting other websites or seeing ads, are common on Google, but they don't contribute significantly to its revenue.

On the other hand, searches with purchase intent, such as "which padel rackets should a beginner buy?", return answers that are different from AI chatbots and traditional Google search. The absence of a single correct answer in "NORA" (No One Right Answer) searches highlights the knowledgeable nature and value of answers from AI chatbots and expert websites.

Google's strategy regarding AI

Google's strategy is to offer users the best of both worlds, providing access to traditional search and responses from AI chatbots without forcing users to choose between them. With their broad user base and versatile approach, they are well positioned to accommodate the platform shift to AI, similar to how they successfully navigated the shift to mobile.

Google recently introduced the Generative Search Experience (SGE), a new feature that directly embeds chat-based responses into searches performed on Google. Meanwhile, Bard, Google's standalone chatbot, is still being maintained, but SGE is looking to tap into Google's broad user base and bring the chatbot experience to a broader audience. As SGE rolls out globally (currently available in select countries with a waiting list for approval), it is expected that a large majority of people will have their first encounter with a “Big Language Model” powered chatbot directly on the traditional Google search page.

Although ChatGPT enjoyed a first-mover advantage, Google's significant distribution advantage across its broad user base presents an opportunity to optimize the integration of chatbot responses and link-based search results based on user needs and preferences.

It is important for investors to understand that while AI will be challenging for some companies, the biggest beneficiaries may not be the companies focused on AI itself. Existing businesses can take advantage of AI to improve their operations, and new businesses can emerge to solve old problems in innovative ways using AI. In essence, implement new technologies to generate economies of scale, as has been done all life in the business world.

The initial impact of AI has already begun, but the backlash is only just emerging. Solutions that address current problems may become outdated as AI tools become more prevalent. It is essential to recognize that the future of AI is uncertain and while its potential is enormous, there are still many unknowns. The key is to stay vigilant and open to the possibilities as AI continues to rapidly evolve.

Scattered expectations

Alphabet's earnings per share (EPS) expectations for the second quarter have experienced modest but notable fluctuation. Initially the projection was $1.38 a year ago, then declined to as low as $1.25 (a -9.4% drop) earlier this year, eventually recovering to the current estimate of $1.34 as we get closer to the results release. The nadir in expectations coincided with a time when Microsoft Corporation (MSFT) seemed to pose a serious challenge to Google's search engine supremacy, leveraging a combination of Bing and ChatGPT. However, as the threat from Microsoft has faded, if not entirely gone, analysts have become more optimistic, leading to a positive upward revision to Alphabet's EPS estimates.

GOOGL Q2 BPA Reviews (Seekingalpha.com)

Of the 27 total earnings per share (EPS) revisions, 22 have been revised upwards, and similarly, of the 27 earnings revisions, 19 have been adjusted upwards. This trend is understandable given the overall slight increase in expectations seen since April, as shown in the chart provided.

Although projected revenue growth below 5% may be somewhat disappointing, the expected EPS growth of almost 11% is quite attractive. It is especially notable to consider the valuation of shares, which further increases the attraction of the potential of shares.
 

The trend does not favor Google

The prevailing “overweight or sell” trend is not in favor of Google. Despite the slight increase in expectations since April, it's important to note that Google has faced challenges consistently exceeding expectations, which may not be beneficial to the company.

The expectation of meeting or exceeding projected numbers has led to mixed results for Google recently. Although the expected EPS growth of almost 11% is promising, the disappointment lies in projected revenue growth, which falls below 5%. Being overly optimistic on results has historically created more disappointment than surprise.

This performance dynamic has raised concerns about Google's ability to consistently beat market expectations, making investors cautious about the stock's future trajectory. The tendency to fall short of expectations or simply miss them can lead to increased scrutiny and have a potential impact on stock performance in the near term.

Over the last 12 quarters (3 years), Alphabet has beaten EPS estimates 8 times (66% of the time) and revenue estimates 9 times (75% of the time), which might seem positive at first glance. However, a closer look reveals a worrying trend. In 4 of the last 5 quarters (80%), Alphabet missed EPS estimates, and in 3 of the last 5 quarters (60%), it missed revenue expectations. Which shows that in the shortest term, Google tends to fall short of expectations. The only respite came in the first quarter of 2023, when the company managed to slightly beat revenue, ending a streak of three consecutive quarters missing revenue estimates.

We should know by now that investing does not include a crystal ball in the manual, trends often provide valuable information. Unfortunately, the current trend is not in favor of Alphabet. As the next results approach, we may see a slight surplus in revenue. Whether or not EPS results in a surplus will likely depend on how disciplined the company has been in its operations, especially in managing expenses. It seems unlikely that any specific division acted as a significant driver of growth in the second quarter.

GOOGL EPS Surprise (Seekingalpha.com)

GOOGL EPS Surprise (%) (Seekingalpha.com)

Advertising and AI: The two main stories

Alphabet's heavy reliance on ad revenue has been an enduring feature of the company, and this is merely a statement of fact rather than criticism. In 2017, advertising represented a significant 86% of the company's total revenue. However, due to the company's diversification efforts into other initiatives such as productivity tools and cloud services, this percentage has gradually decreased to 79% in recent times. Despite this reduction, ad revenue remains a crucial component, raising concerns when Microsoft aggressively jumped on AI technology, initially catching them off guard.

Focusing on advertising, before the surge caused by the COVID pandemic in 2021, the growth rate of advertising revenue had been in decline for the previous three years, falling from 22% to 15% and then to 9%. This trend has persisted, with 2022 showing a meager 7% growth in advertising revenue compared to the peak reached in 2021. In the first quarter of 2023, the company was still facing challenges in its search and advertising business, indicating that the pressure continued.

Given this context, it is possible that advertising revenue will remain slightly below 80% of total revenue, which would represent around $57 billion of total projected revenue of approximately $72 billion.

Revenue from Alphabet (fourweekmba.com)

According to a recent report from Seeking Alpha, competition in artificial intelligence is heating up at Alphabet, and the company has finally recognized the urgency of addressing the threat it poses to its search business, not just from Microsoft, but from AI technology in general. To meet this challenge, Alphabet has brought back one of its esteemed co-founders to lead an initiative, a stock that has captured the attention and excitement of Wall Street. As we await second quarter earnings releases, more details about the company's plans for Gemini (Google's chatbot) and how it intends to integrate its AI advances into Google's broader ecosystem, which includes productivity apps, Google Cloud and, of course, Search, are eagerly awaited.

As for Google Cloud, although it has been perceived as a minor contributor to the company's overall position in the market, the division reported its first profitable quarter in the first quarter of the year. The crucial question now is whether this performance was a one-time event or whether it signals a positive trend. For the second quarter, skepticism still lingers about its potential to achieve two consecutive profitable quarters, indicating that the maturity and long-term importance of Google Cloud remains under scrutiny. However, many analysts expect Google Cloud to play a more significant role in the company's future growth trajectory.

Valuation - The best among the largest

Looking at results, Alphabet has a 12-month P/E multiple of 22x earnings, is much cheaper than Apple Inc. (AAPL.US) at 32x, Microsoft (MSFT.US) at 35x and Amazon.com, Inc. (AMZN.US) at 82x.

The valuation becomes more attractive when the expected earnings growth rate of almost 16% per year over the next 5 years is taken into account. This puts the stock at a price-earnings/growth ("PEG") of 1.40x. Although this is a bit higher than some well-known financial gurus would like, Apple's (AAPL.US) PEG is >4x and Microsoft's (MSFT.US) is >3x. Only Amazon (AMZN.US) has a PEG comparable to Alphabet, but this is based on a lofty earnings growth expectation of nearly 65%.

Mega-cap tech stocks have had such a magical run this year that Alphabet, with 34% appreciation, is the “worst” performer, while Microsoft has 43%, Apple 53% and Amazon 51%. Given relative undervaluation and underperformance, Alphabet is facing results with subdued expectations, and upside surprises in second-quarter results or, more importantly, third-quarter guidance, could set the stock up for a rally.

Technical Strength - Built on a strong foundation

Alphabet Inc. (GOOGL.US) shares have successfully broken out of the important 100-day and 200-day moving averages, as shown in the data provided. Furthermore, the other short-term moving averages are also very close to the current share price. This development establishes a solid foundation for actions as the publication of its results approaches.

Source: GOOGL Moving Avgs (Barchart.com)

With such a strong foundation in place, a positive earnings report and/or strong guidance could push stocks further away from these moving averages and establish a new level of support. This potential scenario would signal greater confidence in the stock's performance and could attract more investor interest in the company.

GOOGL.US, D1. Source: xStation

Currently, the Relative Strength Index ("RSI") for stocks is slightly below what would be desirable, suggesting that there may not be substantial emotion or momentum around them at present. Despite this, however, stocks look strong enough to indicate that a positive earnings report and strong guidance will likely act as catalysts for a potential rally.

Conclusion

Despite the notable rise in share value, the Google ecosystem has not received the same level of recognition as the mainstream Microsoft or Amazon ecosystem, creating an opportunity for further appreciation, due to divergent behaviors.

Google has a unique advantage in being able to harness artificial intelligence across its wide range of products and services, leading to greater productivity for its users and improving its profitability. It is important to recognize that, despite the excitement around artificial intelligence, Google maintains a significant competitive advantage in advertising and Search, representing a significant MOAT (The ability of a company to maintain competitive advantages over its competitors in order to protect its long-term profits and market share.) that differentiates it from its competitors.

Taking these factors into account, Google has a strong position in the market and the potential for further growth. Anticipating promising prospects for the future performance of the company. Even if the next earnings report is not in line with expectations.

Small tip for the end, in the last four years the company has added more than 100,000 employees to the workforce. You can see this data in the lower right hand corner of the Google Fundamental Summary below. That is an increase in the period of 100%. So it would not be strange if he opted for a cut as there would be space to do so. And this would drive the price towards the potential targets set.

Source: XTB Research

Dario Garcia, EFA
XTB Spain