Setting the Stage
When ChatGPT took the world by storm in early 2023, investors significantly reduced their exposure to Google shares and we felt the reaction was way overdone. At that juncture, Google had become extremely cheap even though it possessed some of if not the best artificial intelligence (AI) capabilities in the world.
Fast forward a year and we – even as devout Google bulls – need to admit that Google has likely fallen behind Microsoft and OpenAI in the artificial intelligence arms race. This is extremely ironic given that Google researchers developed the “transformers” architecture which enabled more effective handling of language understanding and generation tasks and provided the foundation upon which OpenAI was built. Google could have had its own ChatGPT back in 2018. But that is a story for another day.
While it is disappointing that Google might have squandered its lead, the game is not yet over. Google lost the battle but not the war. And for that reason, we believe the market is severely over-discounting Google’s AI capabilities, something we noted during a recent BNN appearance on March 12, 2024. At current prices, we could make the argument that the market is giving a negligible value for Google’s AI capabilities, which is entirely unreasonable. We think that Google can win the AI arms race with current management but would prefer to see big changes at the top.
Pieces of the AI Puzzle
When we think about the key ingredients needed to win in AI, Google has all of them. GOOGL has 1) Talent, 2) Infrastructure and 3) Data.
- While we can argue about Google’s reputation as the global leader in AI, there is no question that the company has a long history of top-tier representation in AI research. For example, Macro Polo’s Global AI Talent Tracker shows that Google remained the #1 global institution for “top-tier” AI researchers in 2022, after having held the same crown position in 2019.
- Google’s business involves the operation of various products and services such as Search, YouTube and Google Cloud (GCP) just to name a few. Google is only able to do this because it has a vast array of global infrastructure that allows its platforms to run 24 hours a day, 7 days a week and 365 days a year. There are not many (if any?) companies with this kind of internet infrastructure. As such, we were not entirely surprised to hear about the rumors of an Apple + Google AI partnership. We are viewing the news as a testament to the scale and quality of Google’s infrastructure. For example – as noted by Stratechery’s Ben Thompson – it is possible that only Google (i.e. And nobody else) has the infrastructure required to service the iPhone user base.
- Google has either the best or second best (after Apple) consumer data in the world. According to Morgan Stanley, the company has six products (including Search and YouTube) with over 2 billion users and another nine products that each serve more than 500 million people and businesses. Google is constantly pulling in highly valuable data, all while improving utility for its users.
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With these three key components in place, we would argue that the bar is very low for Google to get back on track.
The Most Important Fight
Like other big tech companies, Google hired thousands of employees in and around the pandemic. This made sense at the time but as inflation and rates started to rise and online ad growth began to decelerate, investors started to pay more attention to profitability and cost discipline. In November of 2022, TCI’s Chris Hohn wrote a letter to Sundar Pichai which outlined some of the issues that are still plaguing the company today. Google has become bloated, with too many employees and excessive employee compensation.
Recent layoffs were a small step in the right direction but barely enough to change the narrative. Companies such as Meta and Twitter (aka X) have shown us that Tech companies can do more with far less. There is no reason that Google can’t follow suit, especially given that even its own employees believe “you could cut the headcount by 50%… and nothing would change”. That is an extreme example but you get the point.
Beyond cost concerns, some have criticized Google for prioritizing political correctness at the expense of factual accuracy. We believe this is justified given that nothing can be allowed to come at the expense of giving us the right answers. Because ultimately, inaccurate results would erode trust from the billions of people that rely on Google on a day-to-day basis.
With that said, it is clear that Gemini’s launch has been a small disaster. Even co-founder Sergey Brin was forced to admit this recently after Google’s image generator was criticized for “historical inaccuracies and questionable responses” that were at least partially driven by a left-leaning bias that the company does not fully understand.
We believe that Google’s problems are fixable and that the company will recover with or without Sundar Pichai. Even so, we would prefer new leadership given that the stakes are higher than ever. This is the most important (technological) fight in the company’s history and they cannot afford to lose. Sundar has overseen Google’s bloating and more importantly, he should be held accountable for the Gemini misfire.
New leadership would be a great excuse for a culture shock. Google needs to get more aggressive and aim for much higher productivity with far fewer employees. We believe that Larry Page or Sergey Brin should come back as CEO. Either of them returning would reinvigorate employees and put the focus back on innovation and hard work. Not to mention, they are exactly the kind AI champions that we need. There are a lot of AI “doomers” out there so having someone who genuinely believes in “AI for good” would make for a great story.
Likely Outcomes
In our base case, Google re-establishes itself as an AI leader and implements a major cost cutting program. This would support both multiple and margin expansion and would further improve the case for a dividend initiation. Considering the quality and scale of Google’s network, we are expecting at least low-double-digit EPS growth for the foreseeable future. This could happen with Sundar, but we believe his exit would be a “Ballmer Moment” for the company. Steve Ballmer was the CEO of Microsoft before Satya Nadella took over. His biggest mistake was “missing” the importance of the iPhone. Well Google cannot afford to “miss” AI. As such, we see massive upside potential if Sundar is replaced, giving the company a new chance for reinvention.
In our bull case, Google (~21x forward earnings) is recognized for its leading AI capabilities and trades in line with other leaders such as Microsoft (~33x) and Nvidia (~36x).
Even in our bear case, Google is undervalued at current prices. If Google fully matures and becomes a “consumer staple”, with little to no revenue growth and mid-to-high single digit EPS growth, then it should at the very least trade in line with other high-quality staples such as WMT (~25x) and PG (~24x).
Data sourced to BBG as of March 31, 2024
Google is a top 10 holding in Middlefield’s Innovation Dividend Fund (TSX: MINN)
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