GOOGLE - Overvalued or Undervalued?

In response to readers' requests in the article “Bank of America ($BAC): Still "Too Big To Fail" With Current Risks?”, this week, Viet Hustler presents to readers an analysis of Google — the tech empire controlling the flow of human information in the modern era.

Google's Q2 financial report was not bad, but Google stock still dropped 10% and dragged the entire market down with it. So why did investors change their minds about Google's valuation? And what is the appropriate valuation for the company at the current time?

Introduction to Alphabet ($GOOG)

Alphabet Inc., Google's parent company, is one of FAANG - the top 5 companies dominating the US multinational online services and technology industry, along with Amazon, Meta, Apple and Netflix.

Famous for its extremely ambitious “moonshot” projects through the X division, Alphabet fosters a culture of experimentation and risk-taking, aiming to solve major challenges with breakthrough solutions. Through subsidiaries like Google, Waymo and DeepMind, Alphabet integrates advanced technology into many aspects of daily life, from search engines to self-driving cars and artificial intelligence.

However, this “experimentation and risk-taking” culture also faces countless issues as Google cancels and pauses many products and projects, causing capital waste and sometimes user frustration through something called “culture of launch” (more on this later)

Summary of Google's history of formation and development:

• 1998: Google was founded by Larry Page and Sergey Brin while they were PhD students at Stanford University. The first Google Doodle was created

• 2001: Launched Google Image Search

• 2004: Launched Gmail

• 2005: Launched Google Maps and announced research partnership with NASA

• 2006: Google acquired YouTube

• 2008: Launched Google Chrome and released Android OS

• 2015: Announced restructuring into Alphabet Inc.

• 2017: Announced restructuring into Google LLC

• 2023: Launched Bard, later renamed to Gemini AI

Leadership team — the captains steering Google to today

1. Google CEO: Sundar Pichai

Sundar Pichai joined Google in 2004 as Senior Vice President in charge of Product Management and then became CEO in 2015.

In 9 years as CEO, he led Google to transform from a search engine giant into a tech powerhouse with diverse products, focusing on modern innovation.

• Pichai oversaw the launch of successful products like Google Home, Pixel smartphones and Chromecast, solidifying Google's presence across various industries.

• Pichai has actively expanded the Google Cloud segment, challenging industry leaders like Amazon Web Services

One of the biggest directional changes Pichai made after becoming CEO is to approach everything with AI first.

• This led to breakthroughs like Google Assistant, image recognition and natural language processing.

• The acquisition of DeepMind - a leading AI research lab - also significantly boosted Google's AI capabilities.

2. Google Cloud CEO: Thomas Kurian

Thomas Kurian officially took over as CEO of Google Cloud in January 2019. Before joining Google, Kurian had a long and successful career at Oracle as Director of Product Development.

Taking over Google Cloud, Kurian launched Anthos — a hybrid and multi-cloud platform that allows customers to write applications once and deploy them on data centers, Google Cloud and third-party cloud platforms, including AWS and Microsoft Azure.

He also refined the Cloud product portfolio, adding support for SAP, VMware, Oracle, Windows and mainframes. Under him, Google Cloud announced the new Google Cloud Partner Advantage channel partner program, enhancing support for service providers to expand reach.

Thanks to Kurian's brilliant management, Cloud has always been one of the fastest-growing segments. After a significant slowdown in FY2023, Cloud growth has accelerated again for the third consecutive quarter.

3. YouTube CEO: Neal Mohan

Unlike Pichai or Kurian, Neal Mohan only took over as YouTube CEO in February 2023. However, he had held the role of Chief Product Officer at the platform since 2015. In his previous role, he made significant contributions to the development and launch of many new features and services:

• YouTube Shorts: YouTube's short video format, directly competing with TikTok.

• YouTube Premium: YouTube's paid service, providing an ad-free video watching experience and other exclusive features.

Recognizing the potential and importance of short-form videos - a market dominated by TikTok, Mohan and YouTube actively invested in and developed Shorts, narrowing the gap between YouTube Shorts and TikTok.

Overview of Alphabet's business model

Although Alphabet's revenue comes from multiple sources, but the main source is still advertising, mainly through Google's search and display advertising platforms. Leveraging its massive user data, Google provides advertising solutions to global businesses, driving revenue growth. Additionally, Alphabet generates profits from cloud computing services, hardware products, and other projects.

• Google Services: a range of services from performance advertising to consumer subscriptions

  • Including segments such as Google Search, YouTube Ads, Google Network, and others

• Google Cloud: focused on providing advanced cloud computing solutions for businesses of all sizes

  • Providing AI-optimized infrastructure, cybersecurity, databases, analytics, and support tools, meeting the growing demand for cloud services.

  • Google currently operates the world's third-largest cloud network, holding over 10% of the cloud computing market share with rapidly increasing revenue.

    

• Other segments: considered side projects of Alphabet.

  • These businesses research innovative solutions in various fields, with a particular focus on healthcare and internet services.

  • Although these businesses may initially incur losses due to their experimental nature, they have the potential to completely transform industries and generate significant revenue in the long term.

Google has acquired 256 companies

This is not a large number although Google has many very successful acquisitions but still always focuses on developing products internally. Google just failed in the acquisition deal of Wiz for $23 billion.

Unique competitive advantages

Google was not the first search engine.

There were many search engines before that, most notably Yahoo. However, after launch, Google quickly defeated competitors to become the number 1 information search platform through simplicity

When Google was founded in 1998, Yahoo's homepage looked like this:

In contrast, Google's homepage looked like this:

A clearer message to consumers: Use this tool to search for anything on the internet.

Simple design, convenient usage, and superior algorithm helped Google capture over 90% of the global search market.

With its massive user network, how has Google converted this volume into revenue? Advertising.

Google's unique competitive advantage is possessing a very effective network effect.

Network effects occur when each new user joins the platform, as users always want to be where there are many other users and advertisers want to advertise where there are many users.

This creates a two-sided network effect: Users attract more users, advertisers attract more advertisers.

• If you see family and friends using a platform, it's hard to resist its appeal

• If there are many users on a platform, you can't let your competitors be the only advertisers for that group.

→ This network effect turns into huge profits for Google and they can use the money to reinvest in the business to attract more users.

• However, it's more than that. Google's network is three-sided: Users, advertisers, and content creators.

• Google continuously collects valuable data for algorithms to help businesses:

  • Reach ads to people who are truly interested in the product

  • Create products that fit needs

→ Increase ad conversion to revenue, making businesses willing to spend more money and users also receive higher quality results.

• The network effect looks like this:

• Google sees that people are searching a lot for specific directions on Google. They notice this and create Maps.

• People are dissatisfied with Microsoft Explorer, they are searching for alternative browsers on Google. Google creates Chrome.

Google observes data, identifies gaps, builds products to meet consumer needs. This is the strongest and most valuable type of network effect because you can use it to increase value for businesses.

→ The 3-party network provides Google with an exclusive competitive advantage over other businesses. At the same time, it anchors users because users can always find services that match their needs.

Thanks to leveraging the massive user network, the advertising segment accounts for the majority of revenue from Google Services and grows at a steady pace

Culture of launching and then killing products

Mentioning Google inevitably means mentioning hundreds of billion-dollar projects that Google has killed, involving the release of hundreds of identical products, which are then merged, killed, transferred, and deleted. Not to mention the very 'annoying' habit for users of constantly renaming products.

Online meetings: Google Hangouts, Google Duo, Google Chat, Google Message, Google Voice, Google Allo, Rooms and finally now Google Meet

Wallets: Google Tez, Android Pay, Google Wallet → Google Pay

Music: Google Music, Google Play → Youtube Music

Email, the most famous product: Google Mail, Gmail, Inbox by Gmail

Social networks: Google+, Google Currents

Even current Google AI products: Bard → Gemini → Gemma

This can be said to originate from Google's 'launch culture.' The corporate culture is that to advance, you must launch a new product. After launching the product, high-productivity members get promoted and continue seeking new products to launch, while low-productivity members stay to manage old products, degrading product quality over time and eventually leading to mergers or shutdowns.

Recently, Google announced the shutdown of the URL shortening tool, and all previously shortened links will no longer work. This means businesses using short links in their products must update them or the old links will die. For long-established businesses that have used this tool for a long time, this creates quite a headache.

• In total, there are 4.6 billion Goo.gl links in use

Competitive risks

OpenAI just launched the product SearchGPT, an AI search tool considered the biggest threat to Google, which is why investors believe Google must catch up by creating a ChatGPT-like model to protect its position.

If Google's competitive advantage is simply the network effect and the ability to meet consumer demands, then a superior service that answers requests better than Google can break it.

However, Google also possesses a powerful weapon no less — the interaction among 3 parties: Users, advertisers, and content creators.

Leaving a platform is very easy if a business can transfer all operations to another platform, try it, find it unsatisfactory, and return without much cost. However:

• If you are a content creator, your business is likely heavily dependent on Google/YouTube for a long time, making it difficult for you to leave Google

  • You either monetize your content through Adsense or provide a service discoverable on Google. Especially if your business depends on Google Ads.

  • You can't leave easily because you've been there too long, invested too much in Google, and have stable revenue streams. Not to mention opportunities for competitors.

• However, if users switch, you have no choice but to switch → the key is whether users have enough motivation to switch.

  • Most people lack the motivation to abandon Google for tools that provide direct answers to customer requests like AI

  • This can be explained by many reasons: Google provides more results than AI: users can synthesize information themselves, cross-reference from different sources, and decide how to convey the information…

    

→ ChatGPT may threaten Google's market share in the information search market, but it is not a serious factor in destroying Google's competitive advantage.

Growth opportunities

Google's potential growth areas in the near future include 3 sectors: AI, Cloud, and Youtube

1. AI

Before OpenAI launched ChatGPT, Google was seen as the leader in the AI race due to the volume of information it can utilize. However, a reason for Google's slow start in this race may be the conflict between its advertising business model and AI.

• If Google successfully develops AI that can answer questions, who will use the search engine?

• If AI's purpose is to autonomously find suitable results, how can Google generate revenue by topping search results?

• How can Google ensure that AI's responses do not conflict with revenue from advertising?

However, everything has changed, and Google is now forced to join the race.

After the early-year scandal with the Bard/Gemini product providing image data that deviated from historical reality, Google pivoted and launched Gemma in two versions: a full one and a lightweight one, running directly on Google Cloud

• LLM Scoring Leaderboard updated 07/23

Overall, Google can benefit immensely by applying AI to its products in the following areas:

For example, what can Google Maps powered by GenAI do?

• You're looking for a restaurant, it can book a table for you, arrange your Uber ride, and pay in advance for you.

• Similarly for most Google apps like Mail, Docs, Chrome, and of course Search.

• All services in the Google ecosystem can integrate and support each other thanks to AI.

2. Cloud

Many investors might think Google was late to the cloud market, but that's not true. AWS was the first among the big three, and Google was second, launching cloud services in 2008, just 2 years after AWS. Microsoft Azure was launched in 2010.

The reason Google has a lower market share than competitors is that the potential of cloud was largely overlooked by Google's leadership, while Microsoft quickly recognized the potential of cloud from the early stages.

However, Google is now aware of it and is growing strongly in the market. In Q2/2024, Cloud reported 29% Y/Y revenue growth compared to 21% for Azure and 17% for AWS in Q1 (MSFT, AMZN have not reported Q2)

Google's annual cloud revenue has exceeded 40 billion USD and is growing at +25%. It's not impossible to think that annual Cloud revenue will reach 100 billion USD in the next 5 years.

3. Youtube

This is probably the best short-term to medium-term opportunity for Google. First, we can see that video is the pinnacle of media forms and social media is gradually shifting to video.

TikTok has proven that videos can be short or long and can be used to deliver any type of message.

People spend less time on Instagram even though it has more users than TikTok. Why? Because Instagram is much more restrictive.

Converting long content to short is easier than short to long. TikTok content creators can easily switch to Youtube, but Youtube creators can't switch to TikTok. This allows Youtube to emulate other platform types. Shorts is a TikTok on Youtube. But Instagram can't upgrade to Youtube.

Youtube's potential is essentially unlimited. People are too focused on the competition between Netflix, Amazon Prime, and Disney+ to see that there is already a winner in the streaming war: Youtube.

Youtube has more watch time than any other streaming service and only trails Disney due to additional legacy TV channels.

That means Youtube is no longer just for small screens. NBA is currently live-streamed on Youtube, you can find your favorite movies on YoutubeTV, and many Youtube channels organize weekly scheduled programs like regular TV.

Over time, Youtube's ad spend market share will only increase while competitors' shares decrease.

Financial Analysis

1. Business Results

Everything looks good for Google as the company is making more money than ever.

Company revenue increased from 161 billion USD in 2019 to 307 billion USD in 2023, with an average annual growth of 13%. This is impressive for a company currently valued at 2 trillion USD.

In 2021, business exploded because most shopping shifted online, retail brands enjoyed their golden days, and businesses recklessly spent on advertising because it was a time of cheap money. Most of that ad money flowed into two companies: Google and Meta. Business boomed. Google's revenue increased 41% in 2021!

Then came the end of the free money era. The Fed raised interest rates and governments began monetary tightening. Google's revenue could actually have declined, but it continued to grow. Google's annual revenue reached 282 billion USD in 2022, but the company's growth rate slowed significantly due to the high 41% base from the previous year.

Note that interest rates are at the highest in two decades, money is expensive, and companies are not considering sharply increasing ad spending. This leaves Google with limited growth opportunities.

With interest rate cuts approaching, we can expect Google's growth to return to low double digits next year, thanks to growth in advertising and cloud segments.

Q2/2024 financial report continues to beat expectations

Revenue by business segment:

• Advertising : 64.6 billion USD (+11% Y/Y).

  • Search: 48.5 billion USD (+14% Y/Y, stable).

  • YouTube ads: 8.7 billion USD (+13% Y/Y, down from 21% in Q1).

  • Networks: 7.4 billion USD (-5% Y/Y).

• Subscription, platforms and devices : 9.3 billion USD (+14% Y/Y).

• Cloud: 10.3 billion USD (+29%, accelerating from +28% Y/Y in Q1).

Key highlights:

• Revenue up +14% Y/Y to 84.7 billion USD (0.5 billion USD above expectations).

• Gross margin 58% (+1pp Y/Y).

• Operating margin 32% (+3pp Y/Y).

  • Services (Advertising and Other) 40% (+5pp Y/Y).

  • Cloud 11% (+6pp Y/Y).

• Earnings: $1.89/share (0.04 USD higher than expected).

2. Google holds $101 billion in cash

Google's balance sheet has virtually no weaknesses.

Google has a massive $101 billion in cash. Google could even acquire all of OpenAI since this business is valued at only $90 billion.

Meanwhile, the company has only $13.2 billion in long-term debt. For a company of Google's scale, that's nothing compared to total equity of $300.7 billion.

The company's EBITDA of $111.5 billion is even 8 times the long-term debt. Google's balance sheet is always managed prudently despite heavy investments in Cloud and AI to accelerate growth. There isn't even a single bad sign in the company's balance sheet.

But on the contrary, this prudence and not using the $101 billion on hand in the current AI race is making many investors unhappy. In the earnings call, CEO Sundar Pichai raised questions about the profitability of AI investments and whether Google should pour more money in at the current time.

• This contrasts with Sam Altman on the mission to achieve AGI at OpenAI: "Even if it costs $100 billion, we will do it"

→ So if Google thinks like a mature stage company, should investors start valuing Google like a mature company?

2. Business Efficiency

• Gross margin

Google is one of the few businesses with the most stable gross margin

Over the past 5 years, the lowest gross margin was 53.58% and the highest was 57.35%.

A stable gross margin shows a business with exceptional pricing power and achieving the optimal price point - the level where they can maximize the number of customers at the same time. If they charge higher, they lose customers. If they charge lower, the profit from customers doesn't offset the lost revenue. This is also the point where business performance predictability is highest.

Google's ability to maintain this optimal price level shows the company feels no competitive pressure, a clear testament to the company's sustainable competitive advantage.

• Net margin

Google's net margin is also extremely stable.

Although there are small fluctuations year to year, on average, the company has converted about 25% of revenue into net profit. The consistency in margins shows the business has no operational missteps.

• Return on equity

Over the past 5 years, Google's average ROE is 23.6%, meaning the company generates $23.6 in income per $100 of equity.

This is more than good since the US companies' average is 12%. This number can vary year to year, but overall, we see that Google generates satisfactory returns from its own money.

Things to watch in the future

1. Project Astra

At I/O, Alphabet announced Project Astra - DeepMind's vision for the future of AI assistants. Astra aims to become a multimodal, real-time AI companion capable of understanding your needs through text, voice, images, and even video.

In a short demo video, Astra identified objects, located lost items, and answered complex questions in a conversational way.

2. SearchGPT

OpenAI is entering the search engine market with SearchGPT, an AI-powered prototype designed to compete directly with Alphabet and Perplexity. Although still in early development, it offers some unique features and demonstrates OpenAI's ambition to reshape how we search for information.

• AI-powered search: SearchGPT leverages the GPT-4 model family and real-time web data to provide direct answers, summaries, and relevant links.

• Conversational interface: Users can refine searches and ask follow-up questions conversationally.

• Partnerships with publishers: OpenAI has partnered with major news organizations to ensure high-quality content and accurate sourcing.

• Publisher controls: Websites can manage their appearance in search results, even if they opt out of AI model training.

• Limited prototype: Plans to integrate into ChatGPT, possibly for 10,000 beta users

• Monetization: Currently free, OpenAI will need to explore monetization strategies in the future.

Search still accounts for 57% of Alphabet's revenue, so SearchAI is still something Google must pay attention to in the coming time.

SearchGPT could shake up the market. Its potential to transform how we search for information is huge. However, OpenAI faces some challenges, including ensuring accuracy and avoiding misinformation, as well as financial limitations.

Information reveals that OpenAI could lose up to $5 billion in 2024 and run out of money next year due to costs related to ChatGPT. Although this startup will compete on product development capabilities, their financial capacity is limited.

Is Google overvalued?

Google's Q2 earnings report wasn't bad, but Google stock still dropped 10% and dragged the entire market down with it. So why have investors changed their minds about Google's valuation?

Google will not be threatened by AI

As Steve explained above, Google's user-advertiser network is too large to be threatened by LLMs. Although the race to AGI has no winner yet, Google's existing products will certainly have a significant advantage when integrated with AI support into the ecosystem.

Google Cloud will continue to grow

The Cloud industry can maintain an average growth rate of 18% per year for the next 7 years, which is a quite reasonable estimate. Not to mention taking market share from AWS or Azure, just maintaining the current 10% market share will mean $230 billion in revenue per year.

Youtube will become the top viewing platform

• Youtube integrates shorts videos like TikTok

• Youtube pushes into movies like Netflix, Disney

• Youtube dives deep into streaming and starts competing with television

• Youtube starts integrating social network products

Youtube advertising generated $8.66 billion in Q2, up 12.9% year-over-year with average growth over the past 3 years of 7.4% per year.

There are many opportunities for Youtube, assuming the growth figure improves and holds steady at 13% per year for the next 7 years, then revenue from this segment in 2032 will be about $95 billion.

Google's competitive advantage in search advertising will be maintained

Google's advertising segment generated $46.2 billion in Q1 and $48.5 billion in Q2, so this segment will generate about $190 billion this year. Currently, the average 3-year growth is 10.7% per year. Assuming a lower growth rate of 10% for 7 years since this market is quite saturated, this segment will bring in $370 billion per year by 2032.

So total revenue 2032:

• Cloud: $230 billion

• Youtube: $95 billion

• Search: $370 billion

Total: $695 billion in revenue for 2032. Currently, Google's price-to-sales ratio is about 6.3; after 7 years, Google will certainly become a mature enterprise and the business decisions from Google in the past 4 years have clearly demonstrated the same, so a slight reduction in the valuation multiple to 5.0 is reasonable, giving an enterprise value of ~$3.5 trillion.

Instead of using a 10% annual discount rate which is the S&P500 benchmark, we subtract a 2% premium because Google is a large company in the market with many advantages. Google's value will be exactly $2 trillion, equal to Google's current market cap today.

So this is the thinking of many investors after the recent earnings report: Google does not show innovation and instill investor confidence in the company's 'beyond expectations' development or the leadership's 'aggressive' and 'risky' spending. Although this is not necessarily bad, it changes the premium amount investors are willing to pay and the perception of Google's position in the growth cycle.

Google's current valuation is reasonable given investors' thinking that:

• Google is not affected by AI with opportunities balanced against competition

• Maintaining 10% market share in Cloud

• Youtube accelerating growth as in the recent quarter

• Search segment continues to maintain its growth rate, not suppressed by SearchGPT