Alphabet seeks to maintain search dominance in AI era
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For a company that started out with a guiding principle of “don’t be evil,” it is ironic that Alphabet (NASDAQ: GOOGL) now finds itself in the crosshairs of government investigations accusing it of acting as a monopolist to maintain its dominant position in the search and online advertising space.Among the drastic solutions the government proposes include a sale of Alphabet’s Chrome search engine. The company also faced another recent investigation into its app store policies.
The quintessential information age company, Alphabet was created in 2015 as a holding company for the search engine company Google and some other subsidiaries. Founded by Stanford University students Larry Page and Sergey Brin, Google was officially incorporated in 1998. At the time of the Google initial public offering in 2004, the founders affirmed in an IPO filing “Don’t be evil. We believe strongly that in the long term, we will be better served - as shareholders and in all other ways - by a company that does good things for the world even if we forgo some short-term gains. This is an important aspect of our culture and is broadly shared within the company. Google users trust our systems to help them with important decisions: medical, financial and many others. Our search results are the best we know how to produce. They are unbiased and objective, and we do not accept payment for them or for inclusion or more frequent updating. We also display advertising, which we work hard to make relevant, and we label it clearly.”
Today, with paid advertising cluttering Google search results, it seems the company hasn’t entirely remained true to its promise of not letting advertisements figure prominently in search results. The S&P 500 company has seen swings in its stock price this year and closed at about $169 on November 25. It remains to be seen what the fallout will be on the company of government investigations. Should investors consider buying Alphabet stock with this shadow looming over the company?
Aiming for AI integration
As it aims to integrate AI more into its business, Alphabet continues to do well financially. For its third quarter ended September 30, 2024, the company reported that its revenues were up 15% over the year, while earnings per share gained 37% to $2.12.
Sundar Pichai, Alphabet CEO, noted, “The momentum across the company is extraordinary. Our commitment to innovation, as well as our long-term focus and investment in AI, are paying off with consumers and partners benefiting from our AI tools. In search, our new AI features are expanding what people can search for and how they search for it. In Cloud, our AI solutions are helping drive deeper product adoption with existing customers, attract new customers and win larger deals. And YouTube’s total ads and subscription revenues surpassed $50 billion over the past four quarters for the first time. We generated strong revenue growth in the quarter, and our ongoing efforts to improve efficiency helped deliver improved margins.” In early 2023, the company announced plans to lay off thousands of workers in a quest to be more efficient.
The company has three different business segments. Google Services generates revenues from advertising, devices such as Google Pixel, consumer subscription-based revenues from services such as YouTube TV and Google One, app sales and in-app purchases. Google Cloud provides services to businesses, generating revenues from services such as Google Cloud Platform and Google Workspace. And its “other bets” segment incorporates a variety of other businesses (such as Waymo, the autonomous driving vehicle) that are not individually significant.
On Alphabet’s third quarter earnings call with analysts, Pichai said that the company is well-positioned to lead in the AI era because of its “full stack” approach to AI innovation. This is based on three different components. “First, a robust AI infrastructure that includes data centers, chips and a global fiber network. Second, world class research teams who are advancing our work with deep, technical AI research, and who are also building the models that power our efforts. And third, a broad global reach through products and platforms that touch billions of people and customers around the world, creating a virtuous cycle.”
Pichai sees the incorporation of AI as an “extraordinary opportunity” for the company. “We are restructuring the company. Effectively, if you think of Google as a neural network, we are forming new synapses, which work much better to adapt to this moment and I think that sets us up well for the year ahead. And we are bringing all of this innovation to the outside world through Cloud as well,” he said.
Considering that AI requires huge amounts of energy, the company is also making clean energy investments and has entered into an agreement to purchase nuclear power “which will enable up to five hundred megawatts of new 24/7 carbon-free power.” The company has also brought about efficiencies at its data centers and made hardware and model improvements. It has brought down the machine costs for its AI overviews search queries by more than 90% in eighteen months, thanks to “hardware, engineering and technical breakthroughs.” Internally too, Alphabet is looking to incorporate AI into its coding processes, with more than 25% of its new code now generated by AI, which is then reviewed and approved by the company’s engineers, which helps them do more with their time. The company also continues to be “laser-focused on building new products.”
In October, the AI overviews feature was extended to more than a hundred new countries, giving it the potential to reach more than a billion users monthly. This is driving more engagement and user satisfaction, according to Pichai, while advertisements incorporated into this feature are also performing well. Other AI features the company has added, such as “Circle to Search” and a Lens visual search are also gaining traction, he said. “For all these AI features, it’s just the beginning, and you’ll see a rapid pace of innovation and progress here,” Pichai noted. He also looks to more opportunity for Waymo, which he sees as a technical leader in the autonomous vehicle industry, “creating a growing commercial opportunity” and engaging in more than 150,000 paid rides each week. The Gemini chatbot has also enabled Alphabet to offer advertisers additional features on Performance Max advertisement campaigns.
Anat Ashkenazi, Alphabet’s chief financial officer, noted that the company has invested about $13 billion in its technical infrastructure in the third quarter, which includes investments in servers (including both Tensor Processing Units and Graphics Processing Units), data centers and networking equipment. Alphabet is also looking to invest about $13 billion in the fourth quarter, with an increased investment in 2025. Ashkenazi also considers it a priority to make the company more operationally efficient, including through the use of AI.
Antitrust cases cast a shadow over Alphabet
The search antitrust case against the company, filed in 2020 by the U.S. Department of Justice together with the attorneys-general of several states, notes, “Two decades ago, Google became the darling of Silicon Valley as a scrappy startup with an innovative way to search the emerging internet. That Google is long gone.” The case seeks “to restrain Google from unlawfully maintaining monopolies in the markets for general search services, search advertising, and general search text advertising in the United States through anticompetitive and exclusionary practices, and to remedy the effects of this conduct.”
For one, Google has deals with Apple and Samsung to make its search engine the default option on Safari browsers and smartphone systems. Google contested the case by saying that users want to use its search engine because they prefer it over others. However, Judge Amit Mehta ruled that Google has emerged as a monopolist in search and it has been able to crowd out search rivals since its default search engine deals have given it access to more data at scale and helped it improve its search results. The court also found that Google was able to raise prices for advertisements as a result of its dominant search position. Among the remedies the government is seeking are a sale of Chrome, Google’s search engine, and sharing of its search results with rivals to put them on an even footing with it.
On the company’s earnings call, Pichai said, “People have chosen us because they view it as the best product, be it consumers or partners. And we have a long track record of working hard to make sure our products are as easily available to use as possible across all platforms. So all the learnings over the years, I think will give us a strong foundation. First of all, we plan to vigorously defend these cases. And some of the early proposals from the DOJ have been far-reaching. I think they could have unintended consequences, particularly to the dynamic tech sector and the American leadership there. And so we plan to engage very vigorously there.”
In another case, the Department of Justice along with some states accused Google of developing a monopoly in the placement of online advertisements. Its 87% market share in that space of technology for online advertisement sales enables it to charge higher prices and take a bigger share of the sales proceeds, according to the government. And one more case against Google brought by Epic Games
accuses the company of colluding with Samsung to deter competition in app distribution, with Samsung’s “auto blocker” feature setting up Google Play Store as the default app distributor on Samsung devices. The company has also been engaged in various legal skirmishes with the European Commission over its search results, advertising and Android-system distribution.
Privacy laws and other risks
The company also faces multiple other risks. For instance, it derives the majority of its revenue from online search (for 2023, 75% of its revenue is from this source) which makes it vulnerable to any changes in technology that block online advertisements or prevent it from customizing advertisements based on search queries. Considering that Google is privy to consumer’s search queries, it is also subject to various privacy laws and regulations. It is facing various investigations in the U.S and Europe relating to its use of search information.
And Alphabet faces competition from others such as Microsoft that are looking to be leaders in the AI space. Its “other bets” division is also engaged in exploring new technologies that may not be successful and also face competition, such as in the autonomous driving vehicle space. Engaging in the development of AI, a new and evolving technology, could also subject the company to cybersecurity, privacy and ethical issues, which could invite government scrutiny and regulation.
Also, founders Larry Page and Sergey Brin hold Alphabet stock’s majority voting power, giving them more influence than other shareholders on voting outcomes. For instance, they may not be agreeable to a merger proposal that other shareholders might prefer to accept.
Moreover, it is not clear whether the principle of “net neutrality,” or equal treatment for Internet traffic by Internet service providers, will continue to be upheld by the incoming Trump Administration.
The company uses derivatives to hedge its exposure to foreign currencies, which is another potential source of risk for Alphabet. And the company is vulnerable to cyberattacks. Another potential negative is changes to international tax policies that the Organization for Economic Cooperation and Development is seeking, such as the adoption of a minimum global tax rate of 15%. This could raise Alphabet’s future tax payments.
Pioneering search algorithm offers some protection
Looking at its financial position, Alphabet’s current ratio of 1.94 means that its current assets are almost double its current assets, putting it on a sound liquidity footing. Its debt is at less than 10% of its equity, which means it hasn’t taken on too much debt. In terms of profitability, the company’s operating margin for the third quarter was at 32%. Its book value per share was $25.61, making for a price-to-book ratio of about 6.6 times. And its earnings per share of $5.80 for 2023 makes for a price-to-earnings ratio of about 29. Looking ahead, its forward P/E ratio of about 19 looks more favorable. The company also initiated dividend payments earlier this year and engages in share buybacks to reward shareholders.
Although the antitrust cases cast a shadow over the company’s future, they could a while to reach a conclusive outcome. And however they play out, Alphabet owns valuable intellectual property in its pioneering search engine. It has also established itself as a first mover in the search space, although other search engines such as DuckDuckGo offer additional search input that provides other perspectives. Microsoft which was subject to antitrust proceedings in the 1990s remains a dominant force in the technology sector. It seems long-term investors could invest in Alphabet, as it seeks to maintain its dominance in the AI era, and wait out the outcome of government investigations.
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Note: I do not own any individual Alphabet stock and I do not intend to take a position in the stock within five days of publication of this post. This write up is my unbiased opinion and not intended as financial advice. All investments carry risks and you should talk to a financial advisor to learn about the suitability of an investment for your portfolio. I did not receive any compensation for this piece that influenced my views.