Interactive Investor

Stockwatch: a buying opportunity soon in this Magnificent Seven stock?

A major event for one of the world’s largest tech companies could create a chance for investors to open a position. Analyst Edmond Jackson explains how things might play out.

7th May 2024 12:03

by Edmond Jackson from interactive investor

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Is Alphabet Inc Class C (NASDAQ:GOOG) re-affirmed as a premier US growth stock, or poised on a precipice as a monopoly trial comes to a head?

Currently near $170, the stock price is exploring all-time highs in a strong rebound after plunging from $148 to $90 from October 2021 to December 2022, when its chatbot “Bard” failed to impress versus ChatGPT devised by OpenAI Inc and Microsoft Corp (NASDAQ:MSFT).

The stock was also caught in a macro tide-change when “growth” sold off, anticipating higher interest rates to check inflation. Concerns about Alphabet’s AI capabilities have persisted with a $150 to $132 slide last February, yet the bull market climbs this wall of worry.

Alphabet performance chart

Source: TradingView. Past performance is not a guide to future performance.

It’s unclear quite whether current strength relates to another bout of optimism on interest rate cuts ahead and buying growth stocks in anticipation. There certainly seem no nerves as the verdict on a major antitrust lawsuit approaches regarding the Google search engine, which is a majority contributor to revenue that makes Alphabet worth over $2 trillion (£1.65 trillion).

It seems possible that a ruling might go against Google in at least some key respects, disrupting rosy sentiment. Might that present a buying opportunity as before (related to AI) on the basis that Google and related Apps remain in premier position – just with not the same dominance? Or, if the judgement tilts against an emerging monopoly, does that mean Alphabet is a “sell”?

It is speculative in advance of any news, but well worth rehearsing the matter so as to be prepared.

US Department of Justice anti-trust case

It is the first monopoly trial of the digital era, recalling action from around 1890 to break up US sugar, steel and railroad monopolies.

From 2020, the Department of Justice and 35 states sued Alphabet’s Google on the basis of abusing power to control the search engine business. Competitors were allegedly sidelined and customers short-changed by getting a lower-quality experience.

That might partly explain why, in July 2021, Google’s underlying momentum enabled Alphabet’s group revenue to advance 62% ahead of expectations. I drew attention to this, suggesting “an excellent operating margin of 31% flags a business to prioritise”. The price was then at a pre-stock split equivalent of $136.

Did this significantly reflect abuse of power? After a 10-week trial last autumn, closing arguments are under way and the ruling could have far-reaching effects on internet use.

I concur with a key aspect of Google’s defence, that its search engine is the simply the best. I find Google offers better reach and depth of information including reviews, for example of goods and services. On setting up a new Windows computer, I change its default search engine from Microsoft Bing to Google in the Bing browser. Microsoft hardly represents a moral example. I find its Bing updates liable to change the search engine default setting back to Bing, hence I have to manually change it again.

The case hinges, however, on business dealings. Google is charged with illegal orchestration with device-makers such as Apple and Samsung, and web browser companies such as Mozilla, which runs Firefox. Witness testimony has cited $26.3 billion spent in 2021 by Google to ensure being the default search engine on phones – principally $18 billion to Apple in 2021.

US government thus contends that Google illegally maintained a monopoly for over a decade.

Google says it is easy for people to switch the default search engine on a device. I would agree versus so many PCs that come loaded with the Windows operating system - is that not effectively a monopoly unless choosing Apple products?

Smaller search engines seem stifled by Google’s dominance, however, reducing innovation towards better products. While its Maps app can work well most of the time it is occasionally a let-down.

Yet Google has not come across well, insisting a lot of the testimony about its business dealings be presented privately instead of via a public court.

The outcome will be decided by a US district judge in weeks, possibly months ahead, with a verdict potentially able to affect Apple Inc (NASDAQ:AAPL) given it is alleged by prosecutors that Google payments to Apple in 2022 comprised 15-20% of Apple’s global net income.

If Google’s contractual arrangements get broken up, then Microsoft could be a high-profile listed beneficiary – raising the profile of Bing.

Strong moat credentials even if monopoly critique upheld

The Google franchise is very strong globally – a circa 65% global share in terms of the Chrome web browser versus Safari, next with around 15%. Specifically on search engine, this may extend to 90%. This is despite Bing gaining reviews seemingly putting it on par with Google Chrome.

Google is proving very hard to disrupt, so Alphabet is in a dominant position just when online advertising is growing by around 10% annually. Since 2021 it has risen from $506 billion to $602 billion and is projected to reach $870 billion in 2027.

Google has a 39% share of global digital ad revenues versus Facebook (Meta Platforms Inc Class A (NASDAQ:META)) on 18% and Inc (NASDAQ:AMZN) with 7%.

Online advertisers get a much better return on investment. On YouTube, for example, they can see exactly how many clicks are being derived from ads, so decide whether to persist with that ad or put money into another.

In terms of operating systems, Google owns Android, which is up-trending versus Microsoft Windows losing share.

Eight of Google’s apps have over a billion users: Google Photos and Google Maps; Gmail has 1.8 billion users; YouTube over 2 billion; Google Playstore over 2.5 billion; Android (acquired 2005) over 2.8 billion; Google Workspace over 3 billion users; the Chrome browser over 3.3 billion users.

Such extent of product network with billions of users – Google also capturing data on them – is powerful longer term for enhancing AI capabilities.

Alphabets Google revenues 2023

$ billion
Google Search and other175
Google other34.7
Google Cloud33
Google Network Members31.5
YouTube ads31.3
Other bets1.5

Attractive free cash flow in Magnificent Seven context

On a price/earnings (PE) basis, Alphabet currently looks fairly priced at around 26x relative to historic strong buying opportunities. It traded on 15x trailing earnings during the 2008-09 recession, and 16-17x at end-2022 when the price was down at $88 after ChatGPT was launched. This also represented a 7.5% earnings yield, well above the return from government bonds.

On free cash flow multiples, Apple trumps with 25.5x versus Alphabet on 28x and Meta Platforms on nearly 30 times and Amazon on 54x. Yet NVIDIA Corp (NASDAQ:NVDA) is on 82x and Tesla Inc (NASDAQ:TSLA) 125x.

Mind, Apple’s revenue has flatlined for two years and started to fall, whereas Google’s revenue has grown in high single-digit percentages - almost in line with other Magnificent Seven businesses.

Potential to exact further efficiencies and augment cash

Google Cloud is notable in this respect as it is not currently factored into Google’s profitability given the business reinvests all its income. Yet as it matures, there are estimates it could add 15% to Alphabet’s group operating profit, and cloud-type businesses tend to have sticky revenues once people are signed up. This would help make the stock look relatively recession-proof.

At end-2023, the group had $111 billion cash/near-term investments and less than $12 billion debt. In principle, cash should be retained for investment where a high return on equity prevails, yet Apple became a target for activist investor Carl Icahn to demand shareholder distributions.

Alphabet is therefore at a crux moment, so watch for the Department of Justice ruling. The stock is impossible to rate until the details are made public and we see market reaction by way of price moves – hence I compromise with: Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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