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Alphabet Inc. aka Google (NASDAQ:GOOG, NASDAQ:GOOGL) stock continues to trade near record highs, as the company’s reputation recovers from previously recurring mishaps on the commercialization of its artificial intelligence ("AI") strategy. Robust Q1 results and signs of continued positive progress in capitalizing on the cyclical recovery of digital ad demand, alongside improved AI monetization clarity, are also supportive of the stock’s recent upsurge. This is further supported by the company’s initiation of a dividend program in line with recent market expectations given its ballooning cash flows.
Specifically, in addition to management’s optimism for ad demand through the remainder of 2024 with incremental cyclical events, recent developments also indicate progress on Google’s AI monetization strategy. This suggests that the company has a clue on how to navigate the AI transition without cannibalizing its existing search leadership, which was previously considered a major growth risk. The additive developments include general availability (“GA”) of Gemini Ultra 1.0 through the Google One AI Premium subscription, and the anticipated GA of SGE on Google Search later this year. Google’s recent announcement of its in-house developed Axion chip is also complementary to its existing AI-optimized Cloud TPU instances by better addressing high inferencing costs.
Taken together, we believe Google is slowly turning a new page and emerging back into the lead in the heated AI race. This is corroborated by recent industry data that shows Google’s stabilizing search market share, while engagement on rivaling generative AI alternatives have started to level off. The trend is also evident in robust search ad revenue growth in Q1.
However, following Google’s post-earnings spike, driven by its reinforced AI monetization outlook and dividend initiation, we believe its market valuation at current levels is reflective of its existing AI roadmap. Looking ahead, we believe the GA of SGE integration into Google Search could become an additive growth driver, making it a critical multiple expansion factor in the near-term.
Stabilizing Search Market Share and Digital Advertising Tailwinds
Google advertising revenue grew by 13% y/y to $61.7 billion in Q1, led by continued resilience in core Google Search advertising demand despite the typical seasonality drop-off. This is consistent with recent industry data, which showed Google Search’s stabilizing share of online queries a year after the debut of generative AI-enabled online search alternatives. Specifically, Google Search’s global share (ex-China) of online queries has stabilized around 92% in February since August 2023. This shows its extent of share loss to generative AI alternatives (e.g. ChatGPT, Microsoft Copilot, Claude, etc.) has been maintained at about 100 bps since February 2023.
The dynamic is corroborated by Google’s recent disclosure of y/y search query growth in the 12 months preceding February at a recent conference:
We’re seeing positive Search query growth in all of our major markets, and this has been consistent over the last 12 months. Let’s say, going back all the way to the end of February of this year, actually, rolling back 12 months. What’s also really interesting to see, and you might have heard this metric before, that roughly 15% of all queries we see every day are new.
Source: Philipp Schindler, SVP and Chief Business Officer of Google at the Morgan Stanley TMT Conference, March 2024.
Meanwhile, emerging generative AI disruptors like ChatGPT and Microsoft Copilot saw their respective web traffic decelerate sharply over the same period with stalling market share gains.
Data from Wedbush Securities and Simplyweb
Stabilizing Google Search traffic and ad demand is further complemented by continued strength in YouTube monetization. Specifically, YouTube ad revenue grew 21% y/y in Q1 to $8.1 billion, accelerating from the prior year despite sequential seasonality weakness. This is consistent with expectations that AVOD platforms remain the highest demand ad format. Ad demand on short-form video and AVOD streaming formats are expected to grow 12% y/y to $22 billion and 13% y/y to $10 billion, respectively, this year.
And YouTube continues to exhibit a competitive advantage in capturing related growth opportunities with its leading market share. YouTube currently dominates the share of U.S. TV screen time at 9.3%, besting Netflix’s (NFLX) 7.8%. The expansive reach, driven primarily by YouTube’s expansive content library, continues to reinforce the platform’s appeal to advertisers.
Continued resilience observed across Google Search and YouTube ad placements – two of the company’s core businesses – also bode favorably heading into incremental digital ad tailwinds in 2H24. These include incremental ad dollar allocations stemming from placements during the upcoming Summer Olympic Games and November Presidential elections. Specifically, industry forecasts currently project $9 billion in non-recurring ad spend this year attributable to the Presidential elections, with digital ad formats – including Google Search and YouTube – being a key beneficiary.
SGE Integration Shouldn’t Be Overlooked
Search Generative Experience (“SGE”) – the highly anticipated generative AI transformation curated for Google Search – has consistently received fewer earnings and media airtime since its launch in May 2023. The feature has largely been overshadowed by increasing market interest in the latest Gemini LLM – as well as controversies over its performance capabilities.
The AI-enabled SGE feature – which differentiates from the typical conversational chatbot format by being a “search native” solution – currently remains in testing phase. The product currently supplements traditional search. In other words, the majority of queries put through traditional search would be complemented by an SGE pop-up that entails generative AI-enabled responses, to which users can further engage with for more accurate responses. The limited access feature has currently rolled out across 120 countries and is available in seven languages. A previously anticipated GA timeline for December 2023 based on Search Lab's SGE Test program has since been removed.
And this is not the first time when GA timelines for Google’s AI offerings have been pushed. A similar trend was observed for Gemini Pro. Following a controversial launch, Google had the Gemini Pro’s original GA timeline in January 2024 quietly removed before officially moving to Gemini Pro 1.5 public preview earlier this month. As for SGE, management remains mum on when the feature will become generally available through Google Search.
We believe eventual SGE integration into Google Search will be critical to reinforcing the engine’s relevance as traditional query-response formats gradually migrate to generative AI formats. With SGE being a search-native generative AI tool aimed at generating more targeted and accurate responses through follow-up queries, the product could better pinpoint consumers’ needs and improve conversion for advertisers.
From a commercial perspective, this reflects SGE’s additive nature to preserving Google’s core search advertising leadership. Recent industry checks performed by Wedbush Securities show SGE responses already accompany about 85% of queries submitted through Google Search in the experimental phase through Google Search Labs. The tool’s ad loads have also already reached similar average levels as traditional search. Especially on mobile interfaces, SGE queries averaged about four ads per search engine result page (“SERP”), which is in line with volumes observed in traditional search.
As Google continues to enhance SGE’s performance and optimize monetization, the eventual GA of the supplementary tool to its search engine could potentially offer additional and higher value ad inventory. This is primarily due to favorable prospects from SGE in generating better ad targeting performance. Specifically, SGE’s capability in generating follow-up prompts could potentially unlock incremental queries and, inadvertently, greater volumes of more effectively targeted ads served. And ad inventory attributable to “more curated SGE responses” will likely generate greater engagement and conversion, thus enhancing return on ad spend (“ROAS”) for advertisers. Not only does this dynamic reinforce the overall search user experience, but it also provides value-added inventory for advertisers, which in turn benefits Google’s core search ads business growth.
We believe continued enhancements to SGE and its prospective GA via traditional search could also complement Google’s current efforts in ramping up AI-enabled tools for advertisers, such as Performance Max (“PMax”).
Current industry forecasts estimate 70% of ad content creation will eventually be overtaken by AI-enabled computer generation in the longer-term, as advertisers look to further optimize their campaigns. By leveraging Google’s proprietary foundation models, SGE could complement the continued ramp up of PMax and other generative AI-enabled advertising tools to unlock further synergies for all of Google’s core advertising business, its advertisers, as well as end-users.
Fundamental Considerations
Adjusting our previous forecast for Google’s Q1 actual performance and outlook, we expect the company to grow revenue by 15% y/y to $352.2 billion in 2024.
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Specifically, we expect Google Cloud to remain its highest growth segment, underpinned by incremental AI-driven cloud opportunities. The unit is expected to grow revenue by 27% y/y to $42.0 billion by the end of this year. Specifically, early-stage accretion from AI-driven cloud TAM expansion is expected to complement ongoing multi-cloud adoption trends, which we find GCP to be a beneficiary of, in becoming key segment growth drivers. This will likely drive continued margin expansion in the segment that has only recently turned profitable.
Meanwhile, for Google’s core advertising business, we expect YouTube to remain a key beneficiary of demand tailwinds for AVOD platforms – particularly in the back half of 2024 ahead of the upcoming Summer Olympics and November presidential elections. Specifically, demand for ad placements on AVOD platforms are expected to grow 13% y/y and exceed $10 billion in 2024. And YouTube remains well-positioned for further capture of related growth opportunities, given its expansive reach with close to 10% share of total TV screen time in the U.S. Search advertising growth is likely to remain stable through the first half of the year, with momentum to pick up in the back half of 2024 as well given impending cyclical events. We expect the continued ramp of AI tools, such as PMax, aimed at helping optimize ad campaigns will become increasingly economically beneficial to both Google and its advertisers.
Taken together, we expect a full year 2024 operating margin of 30%, in line with expansion observed in the first quarter. This compares to full year 2023’s 27%, with the anticipated increase in profitability coming primarily from ongoing cost realignment initiatives that include the latest job cuts and organizational reshuffle. The continued ramp up of generative AI solution deployments is expected to be incrementally, though nominally, accretive to Google’s bottom-line this year as well.
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Price Considerations
Our updated price target of $176 (previously $147) is based on the discounted cash flow, or DCF, approach. This is consistent with the stock’s post-earnings price of about $177 in post-market trading following its Q1 release on April 25.
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The analysis considers projected cash flows taken with the base case fundamental forecast above. A 10.3% WACC in line with Google’s capital structure and risk profile is applied, alongside an estimated perpetual growth rate of 2% on terminal cash flows. The valuation assumptions that we have applied will remain unchanged from our previous forecast, as Google’s forward outlook continues to progress positively with no material changes to the anticipated trajectory.
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Upside Scenario Considerations
As mentioned in the earlier section, we view the eventual GA of SGE in Google Search as a potential near-term catalyst for the stock. We believe the solution will further reinforce Google Search’s leading market share and reduce its exposure from competition and disruption.
In the upside scenario, we set a price target of $185 for Google. The price reflects higher growth across Google’s search ad cash flow stream, given expectations for additive opportunities stemming from SGE ad inventory. The valuation analysis maintains the same key valuation assumptions (i.e., 10.3% WACC and 2% perpetual growth rate) as the base case analysis.
Conclusion
Sentiment for the Google stock has improved greatly since our last coverage, supported by a noticeable increase in clarity on Google’s AI monetization strategy. This is evident in robust GCP growth observed in Q1, complemented by resilience in the core search advertising business, which corroborates stability in market share against disruption of AI-enabled alternatives.
Admittedly, Google’s unmatched first-party data advantage remains unmatched, which remains favorable for its long-term AI strategy. Its breadth of AI offerings – spanning AI-optimized hardware, proprietary chips and foundation models, and end-market tools – also remain key competitive advantages amidst the ongoing industry AI transformation.
However, we believe that Google’s stock price at current levels is fairly reflective of its existing AI roadmap. Further multiple expansion would likely require incremental growth catalysts, such as the GA of SGE and ramp-up of relevant ad inventories.
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