Alphabet Inc. (GOOGL) is the holding company of Google, a tech giant offering a wide range of technological products in the likes of search engine, maps, calendar, mail, operating system. GOOGL also sells hardware products and online advertising services. GOOGL’s reporting segments are Google Services, Google Cloud, and Other Bets. In terms of global market share for search engine, GOOGL has 92%..
Investment Overview
Generative AI in GOOGL’s search could bring greater monetization capabilities. The high performing segment in GOOGL is the Google Services segment which generated operating margin of 35% in 2Q23. GOOGL’s Services segment is expected to record similar margins given the scale in Search (65% of service revenue), YouTube (12%), Third-party ad-tech revenue (12%) and others. GOOGL unveiled its next generation search engine integrating Generative AI generating responses akin to Bard and ChatGPT while providing links/sources for further exploration. The integration of these AI features, along with GOOGL's extensive Shopping graph which has 35bn product listings, is expected to facilitate the transition from offline to online spending and solidify search's competitive position in the online ad ecosystem. GOOGL currently holds more than 92% of search market share. Street projects Google Services revenue to grow at a CAGR of 14% over FY23F-25F.
GOOGL’s Cloud (GCP) margins have big room to improve. GOOGL’s cloud segment’s operating margins turned positive in 1Q23 (+2.6%) while reported 5.0% margin on a revenue of US$8bn (+28% y-o-y) in 2Q23. When AMZN recorded similar revenue levels in cloud in 2018, the operating margins stood at 28%. While the market is more competitive today, there is tremendous room for margin improvement. AWS accounts for 32% share of this global market while Azure and GCP accounted 23% and 9% respectively. Global enterprise spending on cloud infrastructure services grew 19% y-o-y to US$66.4bn in 1Q23 with annual growth rate falling below 20% for the first time due to macro uncertainties, and the cloud segment might see some slower growth in the near term. GCP is still way behind AWS and AZURE in terms of operating margins of 24% and 43% respectively. It is possible for GCP to increase operating margin to 20% by 2025. At this rate, the operating income for GCP would be US$11bn on a revenue base of US$55bn. Street estimates GCP revenue CAGR of 35% over FY23F-25F.
Some positives for GOOGL’s ad-tech segment (12% of its 2Q23 service revenue). Proposed end of third-party cookie support, which other browsers like Safari and Firefox have discontinued for years has been delayed again. GOOGL will disable third-party cookies for 1% of Chrome users in 1Q24F and completely disable third-party cookies in 2H24F. Privacy Sandbox solutions would replace cookies to address the user privacy issue and a delay in phasing out cookies will enable these new solutions to be further tested and accepted by industry. GOOGL claims that this new solution can be 95% as effective as cookies.
GOOGL’s share price has been susceptible in the past due to revenue growth and margin trends and this could be impacted by further deterioration in macro-economic conditions. Other downside risks include mobile transition triggering negative search behavior changes, revenue growth pressure from competitor initiatives, margin disappointment owing to revenue mix and investment initiatives, and negative regulatory changes.
With GOOGL ahead of its peers in AI adoption across its products, at par with MSFT perhaps, we advocate GOOGL to trade at its peer multiple of 27x translating to a 25% discount to our target multiple of 36x for MSFT. Street projects FY23F-25F earnings CAGR 15% at GOOGL vs 13% CAGR average for its peers.
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