Stock of the week - Alphabet (26.09.2024)

Google, a subsidiary of Alphabet Inc., remains a leader in the technology market in 2024. The company's recent financial results for the second quarter of 2024 not only exceeded analysts' expectations but also highlighted its growing strength in cloud computing and continued commitment to artificial intelligence (AI) development. The main challenges that may negatively impact the company include antitrust proceedings regarding the monopolization of the digital advertising market, increasing regulatory scrutiny (especially in EU markets), and intensifying competition in the AI and cloud services space.

Brief summary:

• Google maintains dominance in the search engine market (91% global share) and achieves growth in its cloud business. Google Cloud reached its first billion in operating profit.
• The company is heavily investing in AI development, doubling year-over-year spending and integrating AI across its product portfolio, including through AI partnerships in mobile devices and AR technology.
• Major challenges include antitrust proceedings regarding digital advertising market monopolization, increasing regulatory scrutiny (especially in EU markets), and intensifying competition in the AI and cloud services space.
• Further development depends on continued AI integration, cloud market growth, development of proprietary chips (TPU), the evolving AR/VR market, and expansion in emerging markets.
• Although financial results remain strong, surpassing analyst estimates, Google faces the challenge of maintaining growth in the face of regulatory and competitive pressure in a rapidly changing technology market.
• Our indicative valuation was $155.23 based on more conservative assumptions and $183.43 based on historical averages.

Alphabet's financial results are growing dynamically 

In the second quarter of 2024, Alphabet presented better-than-expected financial results, with total revenue reaching $84.7 billion, representing a 13.6% year-over-year increase and surpassing the analyst consensus of $84.3 billion. The company's earnings per share (EPS) of $1.89 also exceeded expectations of $1.85 per share, representing a significant 31% jump compared to the same period last year.

Advertising revenue, the company's main source of income, reached $64.6 billion, slightly exceeding analysts' forecasts of $64.5 billion. However, YouTube advertising revenue was $8.66 billion, which was below analysts' expectations of $8.95 billion. YouTube remains a key part of Google's ecosystem, and the company is actively exploring new monetization strategies, including subscription services such as YouTube Premium, YouTube TV, or video pause ads.

The Google Cloud segment recorded impressive growth, generating revenue of $10.35 billion, surpassing analyst estimates of $10.1 billion. Moreover, Google Cloud's operating income was $1.17 billion, significantly exceeding analysts' expectations of $982.2 million.

Alphabet's operating margin increased by 310 basis points, reaching 32.4%, indicating improved operational efficiency. However, it's worth noting that Google Cloud's operating margin of 11% still lags behind competitors - Microsoft Cloud with a 35.7% margin and AWS Cloud with a 38% margin.

Alphabet also increased its investments in AI model development, spending $2.2 billion in the second quarter of 2024, which is double the $1.1 billion spent in the same period last year. This indicates the company's strategic commitment to AI technology development.

Looking at the indicators, Alphabet seems to be valued lower by the market than its competitors. One reason for the price decline and lower P/E and forward P/E ratios may be legal issues, which are discussed later in the text.

New horizons: Google on the brink of AR and AI revolution 

Google Cloud's success is partially attributed to its innovative technologies, particularly its proprietary Tensor Processing Units (TPU) optimized for AI and machine learning workloads. The adoption of TPUs by major clients such as Apple for training AI models demonstrates their competitive advantage and positions Google well in the rapidly developing AI market.

The Android operating system, powering over 70% of the world's smartphones, provides Google with an enormous user base for its mobile services and applications. Although not directly monetized, Android's dominance ensures that Google's services remain at the forefront of mobile data processing, driving advertising revenue and data collection.

Google's commitment to AI development is evident in increased spending in this area. In Q2 2024, Alphabet reported spending $2.2 billion on building AI models within DeepMind and Google Research organizations, doubling the $1.1 billion spent in Q2 2023. Recent developments highlight Google's strategic focus on AI and emerging technologies. The partnership with Samsung brings Google's AI capabilities to the popular Galaxy smartphone line, expanding Google AI's reach in the mobile market. Additionally, collaboration with Qualcomm and Samsung on AR glasses signals Google's renewed focus on augmented reality technology, potentially opening new markets and use cases for Google's AI capabilities and software.

Legal challenges

Google faces significant challenges and risks. The company is currently undergoing antitrust proceedings, particularly regarding its dominance in the digital advertising market. This poses a potential risk, ranging from high fines to forced divestiture of parts of the adtech business. Regulatory scrutiny, especially in EU markets, reduces operability and may affect the company's ability to innovate and expand some services. Alphabet Inc., Google's parent company, is currently subject to numerous legal and regulatory proceedings worldwide. In the United States, two antitrust proceedings are underway: one concerning the digital advertising market, the other regarding dominance in the internet search sector. In a landmark copyright infringement case against Oracle, concerning the use of Java APIs, the US Supreme Court ruled in favor of Google. The corporation settled for $350 million in connection with a data security breach in Google+. In the European Union, Google has been fined over 8 billion euros for monopolistic practices. In the UK, the company settled for $1.2 billion in a case involving user privacy violations. Additionally, in India, Google was fined $161 million for abusing its dominant position in the mobile app market. The above proceedings illustrate the complexity of regulatory challenges Google faces globally, particularly in the areas of competition law, personal data protection, and intellectual property rights.

Fierce battle in cloud and AI

Competition in the AI space is intensifying, with rivals such as Microsoft and Amazon making significant progress. The growth of open AI models, such as Meta's Llama, Claude, or Chat GPT, poses a challenge to Google's AI offering. In cloud services, intense competition from AWS and Azure puts pressure on Google Cloud. The rapid evolution of AI technology requires Google to continuously adapt its search and advertising services to maintain their relevance and effectiveness. Changes in user behavior, such as increased reliance on social media platforms for information discovery, pose challenges to Google's traditional search-centric model.

Valuation:

We decided to base our assumptions on data based on averages from the last 5 years and Wall Street forecasts, assuming a slightly smaller decrease in capex. We assumed 13% revenue growth and 32% operating margin for 5 years of forecasts. The decision to prepare 5 years of detailed forecasts is based on relevant data and historical averages.

Since the terminal value typically constitutes a significant portion of the DCF valuation, especially with shorter periods of detailed forecasts, we decided to take a very conservative approach. For terminal value calculations, we applied a 3% revenue growth and an 11% terminal WACC, identical to the WACC used for the 5-year forecasts. This set of assumptions gives us an intrinsic value of $183.43 per share, offering about 13.6% growth potential compared to the current market value.

At the same time, we considered an identical scenario, with the operating margin reduced to 25%. For the same assumptions but lower margin, we obtained an intrinsic value of $155.23 per share, which is sligthly below the current market valuations.

It should be noted that the intrinsic value obtained by the DCF method is very sensitive to the assumptions made. Below are two sensitivity matrices for the more conservative assumption, i.e., 25% operating margin - one for different sets of assumptions regarding operating margin and revenue growth, and another for different assumptions regarding terminal WACC and terminal revenue growth.

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

Next, let's look at how Alphabet compares to the competition. We created a peer group consisting of 4 companies whose business model and growth may be similar to Alphabet: Microsoft, Apple, Amazon, and Meta. As can be seen, Alphabet is below average for most indicators, which is particularly visible in the current P/E and forward P/E.

Source: Bloomberg Finance LP, XTB Research

We calculated the average, median, and capitalization-weighted ratios for the peer group. Then, three different Alphabet valuations were calculated for each of these ratios. As can be seen in the table below, each of them suggests that Alphabet shares are undervalued at current prices relative to peers. Most indicators are also in the vicinity of the 12-month average price forecast by analysts, which is $228.81.

Recommendations: Alphabet has 69 recommendations, of which 57 are "buy" with the highest price of $234.59 and 12 are "hold" with the lowest price of $170. The 12-month average forecast price is $228.81 and is 26% above the market price.

Technical analysis: Alphabet's stock price is in an interesting place, between two Fibonacci retracements and two moving averages. On September 18, the price crossed above the 30-day SMA and has been trying to maintain above it since then. In case of a downward movement, it will be the first support, with the 200-day SMA being the second support. The long-term average is also at the 23.6% Fibonacci retracement of $157.71. Breaking it may indicate a continuation of the downward trend. At the same time, an inverse head and shoulders formation may be forming. Breaking the downward trend may indicate a reversal of this movement and the beginning of a bullish divergence. RSI is also in a downward trend that has been ongoing for a year, the denial of which will be visible after higher peaks and higher lows. Otherwise, the downward trend may continue.