As the company’s reputation recovers from previously recurring errors on the commercialization of its artificial intelligence (“AI”) strategy, Alphabet Inc., aka Google (NASDAQ: GOOG, NASDAQ: GOOGL), stock continues to trade near record highs. Robust Q1 results and signs of continuing progress in capitalizing on the continuous recovery of modern ad demand, alongside improved artificial monetization clarity, also favor the stock’s current upsurge. Given its rising money flows, the bank’s initiation of a payout program in line with current market expectations additionally supports this.
In particular, recent developments indicate progress on Google’s AI marketing plan in addition to management’s enthusiasm for advertising demand through the remainder of 2024 with progressive seasonal events. This suggests that the company has a handle on how to manage the AI shift without cannibalizing its existing research command, which was previously considered a major expansion risk. The additions include the anticipated GA of SGE on Google Search later this year and the general availability (“GA”) of Gemini Ultra 1.0 through the Google One AI Premium subscription. Google’s most recent statement regarding its in-house-created Axion chip is also a better way to address high inferencing costs than its already AI-optimized Cloud TPU instances.
Taken together, we believe Google is slowly turning a new website and emerging again as the guide in the heated AI culture. Recent market data confirm this, showing that Google’s stabilizing search market share is declining while generative AI competitors’ proposal has started to decline. Strong growth in research advertising revenue in Q1 also demonstrates the pattern.
But, following Google’s post-earnings rise, driven by its reinforced artificial monetization outlook and dividend initiation, we believe its market valuation at present levels is indicative of its existing artificial roadmap. We anticipate that Google’s GA of SGE integration will play a significant role in the near term, making it a significant multiple expansion factor.
Stabilizing Search Market Share and Digital Advertising’s Rewinds
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 in line with recent industry data, which revealed that, one year after the release of generative AI-enabled online search alternatives, Google Search’s stabilizing share of online queries. Since August 2023, Google Search’s global share of online searches (ex-Chinese) has stabilized at around 92% in February. This shows its extent of share loss to generative AI alternatives (e.g., ChatGPT, Microsoft Copilot, Claude, etc.) has been upped to about 100 bps since February 2023.
The trend is supported by Google’s most recent disclosure of y/y search query growth in the twelve months prior to 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, rolling back 12 months, starting at the end of February of this year, or even going back in time. What’s also really interesting to see is that, as you might have known, 15% of all queries we see every day are new, which is something you might have heard before.
Source: Philipp Schindler, SVP and Chief Business Officer of Google at the Morgan Stanley TMT Conference, March 2024.
Meanwhile, emergence-based generative AI disruptors like ChatGPT and Microsoft Copilot experienced a sharp decline in web traffic over the same time period, with stalling market share gains.
Data comes from Simplyweb and Wedbush Securities.
Stabilizing Google Search traffic and ad demand is further complemented by continued strength in YouTube monetization. In particular, despite weak seasonality in the previous quarter, YouTube ad revenue increased by 21% y/y in Q1 to $8.1 billion, increasing from the previous year. This is in line with what is anticipated, and AVOD platforms continue to be the most popular ad format. Ad demand on short-form video and AVOD streaming formats is expected to grow 12% y/y to $22 billion and 13% y/y to $10 billion, respectively, this year.
And YouTube continues to have a competitive advantage by securing lucrative growth opportunities from its market share. Netflix’s (NFLX) 7.8% and Netflix’s (NYT) 9.3% of U.S. TV screen time are currently at the top. The expansive reach, driven primarily by YouTube’s expansive content library, continues to reinforce the platform’s appeal to advertisers.
The company’s core businesses, Google Search and YouTube, both showing signs of continued resilience, both of which predict the company’s ability to experience incremental digital ad tailwinds in 2H24. These include additional ad dollar allocations resulting from placements during the upcoming Summer Olympics 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 Should Not Be Disregarded.
Since its launch in May 2023, the highly anticipated generative AI transformation known as SGE has consistently received fewer earnings and media airtime. 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 stands out as a “search-native” solution from the typical conversational chatbot format, is still in testing phase. The product is currently an improvement to 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 is currently in seven languages and has been implemented in 120 countries. 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. For the Gemini Pro, a similar pattern was observed. Following a contentious launch, Google quietly removed the Gemini Pro’s original GA timeline in January 2024 before releasing the 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.
As traditional query-response formats transition to generative AI formats, we think Google Search’s eventual SGE integration will be crucial for enhancing its relevance. SGE, a search-native generative AI tool intended to deliver more targeted and accurate responses through follow-up queries, could better identify consumers’ needs and increase conversion for advertisers.
From a commercial perspective, this reflects SGE’s additive nature to preserving Google’s core search advertising leadership. SGE responses are already present in about 85% of queries submitted through Google Search in the initial stages of the Google Search Labs, according to recent industry studies conducted by Wedbush Securities. The tool’s ad loads have also already reached a similar average 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.
The eventual GA of the supplementary tool to Google’s search engine could potentially provide additional and higher value ad inventory as Google continues to improve SGE’s performance and optimize monetization. This is primarily due to SGE’s favorable chances of producing 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. Additionally, “more curated SGE responses” are likely to increase engagement and conversion, improving return on ad spend (“ROAS”) for advertisers. This dynamic not only improves the overall user experience for Google, but it also generates value-added inventory for advertisers, which in turn aids in Google’s expansion of its core search ads business.
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”).
As advertisers look to further optimize their campaigns, industry forecasts predict that 70% of ad content creation will eventually be overtaken by AI-enabled computer generation in the long run. SGE could complement the ongoing ramp-up of PMax and other generative AI-enabled advertising tools by utilizing Google’s proprietary foundation models to unlock additional synergies for all of Google’s core advertising business, its advertisers, as well as end-users.
Fundamental Considerations
We anticipate that Google’s revenue will increase by 15% y/y over the course of the company’s current and future forecasts for Q1 and beyond.
We specifically anticipate that Google Cloud will continue to be its highest growth segment, supported 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. In particular, early-stage growth from AI-driven cloud TAM expansion is anticipated to complement ongoing multi-cloud adoption trends, which we believe GCP to be a beneficiary of, by acting as key segment growth drivers. This will likely encourage the segment’s margin growth to increase as it has only recently become 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. In particular, demand for ad placements on AVOD platforms is projected to increase by 13% y/y and reach $10 billion by 2024. And YouTube is well-positioned to take advantage of related growth opportunities given its vast reach, which accounts for close to 10% of total TV screen time in the United States. Search advertising growth is likely to remain stable through the first half of the year, with momentum picking 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.
We anticipate a 30% operating margin for the full year 2024, which is in line with the growth observed in the first quarter. In contrast, this is 27% for the full year in 2023, with the anticipated increase in profitability being primarily caused by ongoing cost realignment initiatives, including the most recent job cuts and organizational reshuffles. 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.
Considerations of Price
Based on the DCF or discounted cash flow approach, our updated price target is now $176 (previously, it was $147). This is consistent with the stock’s post-earnings price of about $177 in post-market trading following its Q1 release on April 25.
The analysis takes into account projected cash flows based on the base case fundamental forecast outlined above. A 10.3% WACC is used in accordance with Google’s capital structure and risk profile, along with a 2% per year rate of permanent growth 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.
Considerations for Upside Scenario
As previously mentioned in the previous section, we see 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.
We set a price target of $185 for Google in the upside scenario. Given expectations for additive opportunities stemming from SGE ad inventory, the price reflects higher growth across Google’s search ad cash flow stream. 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
Since our last coverage, sentiment for the Google stock has significantly increased, thanks in part to a noticeable improvement in the clarity of Google’s AI monetization strategy. This is demonstrated by the robust GCP growth that was observed in Q1, as well as resilience in the core search advertising industry, which supports stability in market share in the face of disruption of AI-enabled alternatives.
Admittedly, Google’s unmatched first-party data advantage remains unmatched, which remains favorable for its long-term AI strategy. In addition, its breadth of AI offerings, which cover proprietary chips and foundation models, AI-optimized hardware, and end-market tools, remain significant competitive advantages despite the ongoing industry AI transformation.
However, we think that Google’s stock price is largely consistent with its current AI strategy. Further multiple expansion would likely require incremental growth catalysts, such as the GA of SGE and ramp-up of relevant ad inventories.
