Alphabet Needs More Than Strong Results to Tame Wall of Worries

(Bloomberg) -- Alphabet Inc. shares have gone nowhere for months, trailing Magnificent Seven peers as investors struggle to price risks confronting the company. It’s a stretch to believe Tuesday’s results will blow away those concerns.

The Google parent’s earnings, due after the close, are expected to show long-term growth trends remain intact. They could also offer new information about any tailwinds it is seeing from artificial intelligence.

But even a positive report may be overshadowed by worries over the unquantified cost of antitrust action, a headache dragging on the stock and making it inexpensive among tech megacaps. Plus, there will be scrutiny over whether Alphabet’s dominant market share in internet search is at risk from other players in AI.

“It’s easy to shout out the company’s valuation, but there are a lot of fears that are hard to quantify, which means you can’t yet tell if it’s a value or a value trap,” said George Cipolloni, a portfolio manager at Penn Mutual Asset Management. “It clearly looks cheap compared to the other Magnificent Seven, but you’re being paid to take a lot of risk, relatively.”

Alphabet shares are up 2.2% over the past six months, the weakest performance among the megacaps. The Bloomberg Magnificent 7 Total Return Index has risen 27% over that period. Shares of Alphabet rose 1.9% on Tuesday.

Alphabet’s results are expected to show revenue growth near 14% and net earnings expansion above 18%. Both these metrics are projected to hold above a double-digit pace over the subsequent years.

Those healthy trends, coupled with Alphabet’s more modest valuation, could mean a lower bar to clear this quarter. Jefferies wrote that Alphabet faces a “less demanding set-up among megacaps” going into earnings, and that the stock should “grind higher over time, driven by fundamentals, though fighting regulatory/antitrust headwinds.”

The shares trade at 19 times estimated earnings, the cheapest among the Magnificent Seven cohort, and a discount to its 10-year average. In contrast, Microsoft Corp., the other major AI software play, trades near 31 times.

Alphabet’s fundamentals and valuation discount stand out among big tech, where investors are increasingly wary about the long-term growth outlook and demanding share-price multiples.

However, the discount also reflects the idiosyncratic risks confronting Alphabet. Antitrust regulation has emerged as a central headwind, ever since a federal judge ruled that Google illegally monopolized the search market.

Earlier this month, the Justice Department told a federal judge it’s considering recommending that Google be forced to sell off parts of its operations. While that is seen as unlikely, and Alphabet is expected to appeal more extreme punishments, the uncertainty could remain a long-term overhang.

Alphabet is also among companies allocating billions of dollars to AI-related capital expenditure, something investors are increasingly wanting to see pay off in terms of improved growth and efficiency. Higher-than-expected spending was a reason the stock sold off in the wake of last quarter’s results.

While AI has boosted demand for the company’s cloud-computing services, Alphabet is also on the defensive protecting its internet search market share from AI alternatives.

Nearly 80% of the company’s 2023 revenue came from Google advertising, according to data compiled by Bloomberg. Less than 11% was derived from Google cloud. On Monday, the Information reported that Meta Platforms Inc. is working on developing an AI search engine to reduce its dependence on Google.

“I’m struggling to know how to handicap these overhangs, since I doubt judges will give Alphabet that lenient a path, and we don’t know whether any erosion in market share will be manageable,” said Matt Stucky, chief equity portfolio manager at Northwestern Mutual Wealth Management. “These concerns are becoming more real than ever in terms of impacting fundamentals.”

Roughly 83% of Wall Street analysts recommend buying Alphabet, a positive consensus that is nevertheless below megacap peers like Microsoft, Amazon.com Inc., or Nvidia Corp., all of which have ratios near or above 90%. However, the average analyst price target points to upside near 20% for Alphabet over the coming 12 months, the highest among megacaps.

“The regulatory headwind is unlikely to be removed in the near term, but in the meantime, Alphabet is a high-quality asset trading at a discount to the market even though it is outgrowing the market,” Stucky said. “That’s a reason to stick with it.”