Does AI revenue potential mean the Alphabet share price is undervalued?

It’s been a tumultuous start to 2023 for Google-owner Alphabet, despite yesterday’s expectations-beating Q1 report that showed positive signs for the digital advertising market it generates most of its revenue from. The tech giant has been buffeted by a combination of the tough market environment for online advertisers and OpenAI’s Microsoft-backed launch of the ChatGPT AI assistant many have seen as a threat to the company’s domination of search.

The explosion onto the scene of the generative AI LLM ChatGPT seemed to spook Alphabet. Big tech rival Microsoft, OpenAI’s biggest investor, has integrated ChatGPT into its Bing search engine (and is doing so across its Office productivity software suite), in an effort to claw back market share from Google.

Microsoft’s move provoked a kneejerk reaction from Google, which hurriedly released its own generative AI assistant, Bard.

In 2021, Google published a research paper that outline safety and accuracy concerns delaying Bard’s launch. If the company had felt those resolved before the late 2022 launch of ChatGPT, it would presumably have launched Bard earlier. It’s doubtful the perceived issues keeping Bard confined to Google’s R&D labs just happened to be ironed out in the weeks after ChatGPT’s public release set nerves jangling among investors.

That doubt was further reinforced during a disastrous early February pre-launch presentation that saw Bard give inaccurate information about which satellite took the first pictures of a planet outside of the Earth’s solar system. When the error was pointed out by news agency Reuters, the Alphabet share price plunged by 9%, wiping $100 billion from the company’s valuation.

The Alphabet share price has staged a recovery in 2023 – can the rally continue?

After a brutal 2022 for tech growth stocks that saw Alphabet’s market capitalisation decline by 39%, the share price has recovered by 16.5% this year, despite the month-long valuation slump that followed the Bard unveiling flop.

Gains so far can be largely put down to markets anticipating a scaling back or pause in interest rate rises after a rapid-fire series of hikes by the Fed last year. Higher interest rates hurt growth stocks because future earnings are less attractive in comparison to higher yields available on newly calibrated fixed-income investments.

Alphabet’s Q1 performance beat analyst expectations

However, a largely positive set of Q1 results published by Alphabet yesterday may give investors fresh impetus in bidding up the company’s share price in the near term. There was also a nerve-settling announcement that Microsoft’s integration of ChatGPT into Bing has shown no sign of impacting the Google search traffic Alphabet relies so heavily on, which has remained stable.

Users have been intrigued by the new AI-infused Bing and drawn to experiment with it. But so far that doesn’t seem to be showing much evidence of translating into them replacing Google with its smaller rival when it comes to day-to-day search requests.

Separately, Microsoft revealed on March 8 that “one third of daily preview users (for Bing) are using Chat daily”, which isn’t as high a percentage as might have been expected given the hype surrounding generative AI chatbots.

The Bing/ChatGPT tie-up may not, in fact, turn out to be the threat to Google’s search market domination it was presumed it could be.

In the short term, investors will be reassured by Alphabet returning to growth over Q1 of 2023 when search ad revenues had been expected to remain flat against the last quarter of 2022, which represented a 2% slowdown. Instead, Alphabet’s Q1 performance beat analyst expectations to show 2% growth against the strong start the company had to last year before the malaise took hold.

Total revenue increased 3% or 6% before currency movements, to $69.8bn against analyst expectations for $68.9 billion. Earnings per share fell to $1.17, from $1.23 the year before but were considerably higher than the predicted $1.06 per share. Total digital advertising revenue came in only slightly below the strong results reported a year ago, sparking hopes of a return to consistent growth after a 4% slide in advertising last quarter.

While Q1 results had a significant challenge to better a strong performance over the same quarter a year ago, coming quarters will benefit from more favourable y-o-y comparisons with weaker periods of 2022. That could see investors further encouraged, spurring more share price growth this year.

Alphabet still well placed to win the AI arms race with Microsoft in the longer term

In the mid to longer term, the mass-market debut of generative AI tools could also be in Alphabet’s favour in the defence of its near monopoly of the search market in many key international markets. Globally, Google has around 93% of the total search market and the ad revenue it generates.

As the company itself points out “AI already powers Google’s core products that help billions of people every day.”

The move to release Bard now, seemingly just to prove Alphabet is not lagging when it comes to its own generative AI pipeline and R&D chops, is still questionable and begs questions. However, with the 2021 announcement the company had spent $100 billion on R&D in five years, unless that money has been squandered with gross inefficiency it can be, and largely is, presumed Alphabet’s own AI IP is more than a match for OpenAI’s.

Analysts cautious on Alphabet have predicted 10-year CAGR of 8.5%, taking full year revenues to $641.9 billion in 2032 from $282.8 billion last year. Any improvement on that, especially if it is significant, should have very favourable implications on the Alphabet share price in relation to its current level.

And while monetisation potential still remains unclear, and so risky, it can be presumed that analysts are not yet pricing in AI-related growth opportunities for Google Search and Google Cloud.

The company is confident that the continued integration of AI will keep on improving the efficiency of its ad platforms, improving ROI for advertisers and encouraging increased spend. AI is also expected to make Google Cloud more competitive against AWS and Microsoft’s Azure as well as the computing power AI tools will need likely to spur a new phase of growth for cloud computing providers as demand rises.

Search engine market share resilience and AI-powered revenue growth could mean Alphabet currently represents a bargain

With the revenue-generating potential of new AI products and AI integration into existing products still unclear, betting on them to boost Alphabet’s value significantly over the next 5-10 years certainly represents a risk. However, if they do fulfil their promise and spur a new period of growth for the biggest tech companies, there is every possibility of gains for investors taking that risk early.