Tech conglomerate Alphabet Inc. (GOOG, Financial) (GOOGL, Financial) is set to ride a wave of positive momentum, both in the long and short term.
In the long term, the significant growth and profitability of the Cloud segment shows promising signs to catch up to larger rivals, along with the company's leading position in search – allowing it to capitalize on new developments from the investments made into generative artificial intelligence.
In the short term, a series of potential catalysts include the upcoming company events to showcase AI capabilities (Google I/O), potential for Gemini image relaunch that could help with sentiment on Google's AI capabilities, the revenue potential from Shorts monetization and the ongoing operating model optimization and reprioritization.
This analysis will delve into the long-term and short-term catalysts that could potentially fuel Alphabet's momentum, as well as my forward views on these factors. But first and foremost, let's dive into the company's outstanding performance recorded in the first quarter of 2024.
First-quarter earnings update
Revenue overview
Source: Alphabet investor relations
In the first quarter, Alphabet significantly exceeded expectations, surpassing consensus estimates for both revenue and earnings. According to Factset data, the company exceeded revenue estimates by approximately $1 billion. The company achieved $80.50 billion in sales, representing a significant 15.40% year-over-year increase. The figure above illustrates this revenue growth was driven by notable advancements in YouTube ads (up 20.90% year over year), Google Search (up 14.40%) and Google Cloud (up 28.40%).
Additionally, Alphabet outperformed consensus expectations in terms of profitability, with an operating margin of 31.60% (a 667 basis point increase from a year ago). More notably, its Google cloud operating margins took a wild upturn – delivering a margin of 9.40% (up 683 basis points). The company's operating income for the quarter amounted to $25.50 billion, reflecting a substantial 32% increase compared to the same period in 2023. On that note, the expansion in profitability can be attributed to better operating leverage – as the higher top line was met with flattish operating costs. Alphabet's earnings per share performance showed remarkable growth as it reported a substantial rise in net income to $23.70 billion (up 57.20%), equating to $1.89 (versus $1.17 last year) diluted net income per share – surpassing consensus estimates by a wide margin.
Net income overview
Source: Alphabet investor relations
Alphabet's capital return potential
A key upside of owning Alphabet lies in its ability to provide significant returns to shareholders through its substantial available free cash flow. In the first quarter alone, it generated free cash flow of $16.80 billion (down 2.20% year over year). Capitalizing on this substantial free cash flow, the management made a historic announcement of a 20 cents cash dividend, scheduled to be paid on June 17. Moreover, the cash dividend is in addition to Alphabet's declaration of a $70 billion share repurchase program, which will further contribute to returning substantial amounts of cash to shareholders. Even before this announcement, Alphabet had been returning capital to its shareholder – evident from its repurchase of $15.70 billion worth of its own shares in the first quarter of 2024 alone – resulting in an impressive 93% cash flow return percentage.
In light of the introduction of both the dividend and share repurchase programs, I expect Alphabet to attract a growing number of investors, consequently driving its value upward in the medium to long term.
Long-term catalyst one: Cloud business
Known for its pioneering search engine, Alphabet has evolved into a multi-faceted entity encompassing a vast array of products and services – spanning from cloud computing and advertising to hardware and artificial intelligence. Amidst this dynamic landscape, the company has shown an excellent trajectory of growth and innovation (evident by its exceptional revenue growth record [compound annual growth rate of 18.50% from 2017 to 2023]). With this, Alphabet derives a lion's share of its revenue from its advertising segment, but with the increasing share of the cloud segment in Google's revenue, it is bringing some much-needed diversity to the revenue mix.
Revenue mix 2017 versus 2023
Source: Alphabet investor relations
Although the Google Cloud segment is consistently increasing its revenue share (Cloud revenues has grown at a CAGR of 41.90% from 2017 to 2023) while also being consistently profitable, it still lags behind larger rivals. According to CRN.com, Google Cloud generated almost three times less than Amazon's (AMZN, Financial) and Microsoft's (MSFT, Financial) cloud businesses. But this segment is showing significant promise, with it now being consistently profitable and continuing to grow at a very healthy rate (recorded positive operation margin in 2023 of 5.20% [9.4% in first-quarter 2024]), but is still low compared to Amazon at 26% and Microsoft at 44%. As the segment expands in the long term, Google Cloud's operating margin is to improve as well. However, I also expect Alphabet will continue to make significant investments to capitalize on the growth opportunities arising from the shift toward cloud-based solutions. Consequently, the margins are expected to remain below those of competitors like Amazon and Microsoft, despite steady improvements.
Google Cloud business operating performance (2018 to 2023)
Source: Alphabet investor relations
Given the widespread shift to cloud-based solutions, I am optimistic about the market's size and rapid growth, enabling all three players (Amazon, Microsoft and Alphabet) to achieve success over the next few years. Google, with its strategic dedication, technological expertise and financial capabilities, is well positioned to continue gaining market share. Nonetheless, capitalizing on the growing market will involve substantial investment, potentially causing Google Cloud's profitability to lag behind that of its peers.
Cloud Infrastructure market share as of fourth-quarter 2023
Source: Statista
Long-term catalyst two: Generative AI and large language models
The generative AI space as a whole has immense potential for revolutionizing various industries – from entertainment to health care and beyond – with its applications being vast and continually expanding. However, several concerns have been raised with regard to the potential impact on Alphabet's leading position in search with the latest developments in the space by competitors like Microsoft (OpenAI), as gen AI technologies usher in the development of more sophisticated and interactive consumer tools, potentially challenging its standing. However, I believe Alphabet's strong position in both the gen AI and search spaces will be unchanged due to the promising development of products.
Alphabet has continued to dedicate significant resources to its investments in gen AI and has done so for several years. I expect its abilities to expand as it continues to invest heavily over the next few years as well. Alphabet has its own products, like Bard, that I expect to evolve and improve due to ongoing investments that will allow the company to maintain its strong position in search and the broader digital advertising market.
I believe Google is way ahead in the AI race – with its leading position stemming from three main factors. First, its extensive volume of research is unparalleled, with 183 papers accepted in 2023 alone, nearly three times more than its closest competitor. Second, Google possesses unparalleled access to vast amounts of data thanks to its 16 services boasting over half a billion daily active users. Finally, Google's robust infrastructure enables it to effectively train and deploy AI models to a wide audience, leveraging its immense reach.
Recently, Alphabet's Gemini Pro 1.5 – its most advanced large language model – was released to the general public, with a free tier limited to 50 requests a day. The Gemini Pro 1.5 is a “multimodal” system – meaning it is able to process image, audio and video inputs, in addition to text inputs (OpenAI's latest version of GPT-4 is currently only able to process text and image inputs).
Short-term catalysts
Apart from the aforementioned long-term catalysts, my optimistic outlook on the company in the short term is derived from several other catalysts, including:
- Google I/O Event – Scheduled for May 14, this annual event is anticipated to introduce new AI integrations across various Google products such as Search, Maps, Android, Cloud and Google Workspace.
- Gemini image generation relaunch – Expected to relaunch in the second quarter, Google is set to introduce an upgraded version of Gemini image generation. This relaunch may involve a gradual rollout, initially granting access to developers or beta testers for human oversight and feedback. The focus may initially target specific use cases like generating product mockups and illustrations for advertisers, which may boost investor sentiment on Gemini.
- Shorts monetization and YouTube revenue – Short-form videos are driving engagement and revenue growth on social media platforms, including YouTube. As Shorts monetization catches up in 2024, we anticipate accelerating revenue growth on YouTube, which could positively impact Alphabet's overall revenue growth trajectory.
- Operating model optimization and reprioritization- Over the past few years, management has placed significant emphasis on the development of innovative new features, all while maintaining a firm grip on cost control. This strategic approach clearly indicates management's strong commitment to achieving a more sustainable operating model that will enhance profitability. Recently, Alphabet has outlined its plans to improve expense efficiency by 2024, which may involve restructuring efforts aimed at reducing both headcount and operational expenses, thereby driving margin expansion. An internal memo from Alphabet's CEO has also informed employees to anticipate further layoffs in 2024, following the previous layoffs in the ad sales unit. These actions underscore the company's ongoing efforts to reassess priorities and invest in its most critical areas.
Thoughts on valuation
Using a discounted cash flow model to assess Alphabet's value over a five-year growth period, a fair price of around $188 per share is projected, representing a roughly 10% increase from current levels on the basis cash flows are anticipated to grow from a forecasted $70 billion in 2024 to $130.50 billion by 2028, with a compounded annual growth rate of 13.30%. These estimates seem plausible given the positive growth drivers identified previously, suggesting potential upside in the company's growth trajectory. As Alphabet solidifies its core businesses and continues to innovate with AI tools to reinforce its position in search, there is room for significant upside beyond investor expectations. Extending the growth horizon to 10 years, a fair value of approximately $241 per share is projected, marking a roughly 40% increase from current levels, further highlighting Alphabet's growth potential.
Despite various bearish arguments against Alphabet, there are no evident flaws or indications of these concerns in its financials. Throughout its history, the company has been a driving force of innovation and now, as a formidable and influential entity, it can innovate on a grander scale with substantial upfront investments while also generously rewarding shareholders. While many large tech companies appear to be thriving presently, the crucial aspect is their trajectory over the next five to 10 years. Given Google's immense scale, I am confident it will only continue to ascend from its current position.
Discounted cash flow analysis – five-year growth exit
Source: valueinvesting.io
Wrapping up
In conclusion, Alphabet stands poised to capitalize on a multitude of catalysts both in the long and short term. The company's robust growth trajectory in the cloud segment, coupled with its pioneering advancements in generative AI, positions it favorably to maintain and expand its market dominance. Short-term catalysts, including upcoming events showcasing AI capabilities and product relaunches, add further momentum to Alphabet's growth story. With a strategic focus on operational efficiency and innovation, Alphabet is primed to deliver significant upside potential for investors in the foreseeable future.
