GOOGL FY23 --Beware the delta

 GOOGL—FY23--Beware the delta

As part of my top 10 holdings series and after their 2023 FY results.

A while ago GOOGL was my largest single holding, around the time the market was fearful that GOOGL knew nothing about AI. Well, that market fear has cooled, the share price is higher, and my shareholding is lower but still in the top 10.

GOOGL is a complex business and my initial analysis of GOOGL did not start until the massive secular online advertising moves had slowed. Google is still growing with the share of advertising moving online plus growth in the general economy, but it is inevitably becoming more of a macro play over time. It could be the most macro-exposed of the super-large US stocks.  That means a lower PE over time.

The last result saw clear evidence that revenues are picking up with the economy. The balance sheet is super strong with $85b in cash. Note below that C19 supercharged returns in 2021 but that the subsequent downturn was not huge, and we have seen a recovery this year. All of these results are indicative of a strong business. the SBC charge is large and subsequently an amount of FCF is most probably allocated to share buybacks and is really an expense.  

The risks to the group are not easy to see in the results and are mainly in the realm of possibilities. These are noted below with my views.

1.      Search remains the domain of GOOGL, it essentially rules this space with a 90% share. The share has remained high for a long time. Search is significant at around 60% of revenues and probably a much higher share of profits. The risks here are multiple. The advent of AI-generated information would potentially disrupt the dominance. How this plays out is unknown and could take many paths, the main issues as I see them are as follows. Firstly, it is likely that the share of queries on search as a percentage of the whole will reduce. That does damage the huge information advantage that GOOGL has over everyone else, the extent and timing are unknown. GOOGLE has a couple of advantages. Firstly, it probably has time, the transactional-related searches are, at this stage, less likely to be the most vulnerable compared, for example, the creative or in-depth data gathering or research searches. Not great but not disastrous at this stage. Secondly, GOOGL is not in denial over the AI threat and appears to be willing to match spending on AI advancement at the expense of profits to attempt to safeguard the search domain. The success of this strategy will not be apparent for some time and, I suspect, sentiment will wax and wane. Big question can the search business be counter positioned and what will management do in this case?

2.      Amazon will continue to gain a share in its e-commerce niche. They already have a reasonably large advertising business and it is difficult to see how GOOGL can stop this where AMZN has customers that limit their searches to AMZN and not on search. The result will be a drag on revenues to some extent.

3.      The AAPL relationship hangs like a sword over the duo. Google pays Apple a huge amount of dollars to make Google the default search engine on iPhones. The amount paid could be heading for $40-50b pa, an enormous sum when Google earned $74b in 2023. The relationship is under trust scrutiny. Unwinding this could be messy for both. The worst case is that AAPL once separated from the GOOGLE payments, is emboldened to commence a search engine with AI and IOS used to attack GOOGL. At least Google will have enormous cashflow to fight but an outcome would be highly uncertain.

4.      The GOOGL culture and management is quite unusual. The company's history has been one of never having to struggle from the start and being flush with cash. Over time that has manifested itself in varying capital allocation, over the last several years that could be criticised as so not being successful. Notably with the challenge to search, there appears to be a positive change. Management has commenced what appears to be a significant cost-cutting and resource allocation to AI at the expense of moon-shot bets.  The expense of making AI dominant in the GOOGL world will be large and potentially tricky.

Management's ability to execute has been mixed. The initial attempts at integrating AI into the search function and LLM have been mixed but adequate. The Subscription strategy makes sense it would add to the strength of the business, but execution is key.

The Cloud business is number three behind AMZN and MSFT. Again, the strategy is sound but not many number three’s end up that successful. The market is large, and execution is key.

GOOGL has the expertise and position to make a good fist in defending their franchise. Management is not in the MSFT and AMZN mould in terms of having GTM and is not successful at monetisation.

Valuation is influenced by a reasonably stable earnings growth profile but for the reasons discussed above the appropriate PE will be an issue as the franchise stability and growth could face some big LT issues that remain largely unknown. My view is that the business is strong and that the management although not overly strong has acknowledged the challenge and has some time and plenty of resources, so the stock is worth holding.

At $143, assuming a 12% eps cagr over the next five years, and a 20X exit multiple gives a 7% return. Not compelling but ok and becomes attractive below $125.

Beware the delta refers to the change coming.

 

Please note the disclaimer.