Summary

• Alphabet's Q4 results were mixed, with revenue missing estimates but EPS exceeding them, leading to a downgrade from STRONG BUY to BUY.

• The company announced a massive $75 billion capex for FY25, raising concerns about the timeline for return on investment.

• Sentiment analysis shows increasing negativity in GOOGL management's outlook, particularly regarding Google Cloud's growth and capacity constraints.

• Despite challenges, Alphabet remains attractive at current levels, but caution is warranted due to declining management sentiment and competitive pressures.

Investment Thesis

The last time I wrote about Alphabet, in October 2024, I analysed the company’s Q3 earnings report and investigated how the company was navigating the challenging competitive landscape that its Search business found itself in. I also dissected the progress made by the company in the AI race. I had a STRONG BUY rating on the stock.

Since the article was published, the stock has gained 1.37%, marginally underperforming the S&P 500, which gained 2.68% during the same period.

In this article, I analyse the company’s Q4 earnings report and investigate whether the significant jump in the company’s projected capex spend can be justified. Furthermore, I analyse GOOGL management’s sentiment during earnings calls and compare it to its peers to examine just how confident and positive the management is with respect to its AI bets relative to its peers.

A Snapshot of Fourth Quarter Results

After building a lot of momentum throughout the fiscal year, Alphabet ended the year on a whimper, with a miss on the top-line. More specifically, Q4 revenues came in at $96.47 billion, and while they were up 11.8% y/y, they missed analyst estimates by nearly $200 million. Diluted EPS of $2.15, however, came in strong, jumping 31% y/y and beating analyst estimates by $0.02, albeit the y/y growth sharply decelerated in Q4, compared to Q3, when it was 37%. The company continued to post impressive operating margins, which once again came in at 32%, expanding by 500 bps (or 5%) y/y. Free cash flows for the quarter came in at $24.8 billion, which resulted in full-year free cash flows of $72.8 billion.

Capital expenditures once again featured prominently in the outlook. Management announced that the company plans to invest approximately $75 billion in 2025, with Q1 capex spend projected to be between $16 to $18 billion. The majority of the spend, unsurprisingly, was earmarked towards technical infrastructure, “including servers and data centers,” highlighting the strong demand that the company sees for AI and cloud. Finally, specifically for Q1, revenues are expected to be negatively impacted by both foreign exchange and the leap year headwinds, the latter implying that there would be one fewer day of revenue in Q1 of FY25 compared to Q1 of FY24.

Cloud Continues to Impress but Capacity Constraints Mean Future Growth Likely to Remain Subdued

Ever since I initiated coverage of Alphabet, I have repeatedly mentioned about how impressive the performance of the company’s Cloud division has been. Q4 was no different, as evidenced by a third consecutive quarter of more than $10 billion in revenue. Operating margins of the segment nearly doubled y/y, coming in at 17.5%, yet another impressive feat.

However, despite posting these impressive numbers, what was concerning was that the revenue growth and the operating margins growth both slowed down, compared to the previous quarter. For instance, in the third quarter, operating margins expanded by 5.49% sequentially. In the fourth quarter however, the expansion slowed down to 0.34% q/q. In terms of revenue, Q3 revenues saw a 9.7% q/q increase and a 35% jump on a y/y basis. Q4, however, saw revenue growth slow down to 5.3% on q/q basis and to 30.1% on a y/y basis. The main reason for this growth deceleration was unsurprisingly capacity constraints, which has become a buzzword among the AI hyperscalers. It has also been the go-to “excuse” for these companies to justify their massive capex spend. Alphabet was no different, as it increased its capex spend for FY25 to $75 billion, attributing the increase to the capacity-demand imbalance.

While having demand in excess of supply is always welcome news, the issue here is if every hyperscaler has a capacity issue, then it is likely that the return on investment on the capex spend is going to take a long time. With respect to Alphabet, the comments from CFO Anat Ashkenazi regarding the projected variability in cloud revenue growth rates in FY25 is concerning to me because it shows a lack of clarity over the timeline regarding when sufficient capacity would be built.

Moreover, in the previous quarter, management did offer some colour on how the AI investments were paying off. More specifically, management announced that the AI investments in the Cloud business led to a “30% deeper product adoption with existing customers.” Investors received no such clarity in the coming quarter, except for anecdotal examples. This, when combined with the warning about variability in cloud revenue growth, causes more confusion than clarity over Google Cloud’s overall growth, compared to its peers. And for a segment that continues to trail both AWS and Azure, this added lack of clarity can have a negative impact on investor sentiment.

At a time when its Search business is not only seeing a growth slowdown but is also getting upended by the likes of ChatGPT and Perplexity, investors are looking to the future growth trajectory of Google Cloud as the next catalyst. In the age of AI, this is a very reasonable bet to make. Till date, among the three hyperscalers (MSFT, AMZN, and GOOGL), there is no clear winner in my opinion. And all three continue to spend massively. However, when you have a lot of catching up to do, the last thing you should do is offer investors more questions than answers. GOOGL’s management, unfortunately did exactly that.

Sentiment Analysis Shows Negativity Creeping into Alphabet Management’s Sentiment

I analysed the management remarks and response to analyst questions of GOOGL, AMZN, and MSFT management, during the earnings call of the last four quarters. Using Python’s TextBlob function, I analysed the earnings call transcripts of the hyperscalers in the last four quarters, and calculated the polarity (measures the degree of positive sentiment and ranges from -1 to +1) and subjectivity (measures the degree of subjectivity and ranges from 0 to 1). The results are shown in the table below.

Comparison of Polarity and Subjectivity of GOOGL, MSFT, and AMZN Management During Earnings Call Over Last 4 Quarters

Given the hype surrounding AI revolution, it is of little surprise that all three hyperscalers have made ambitious forward-looking statements in each of the last four quarters, as evidenced by the strong subjectivity figures. While the degree of subjectivity declined for each of the companies, they largely remained very high, underlying the degree of confidence that the management has with respect to their AI plans. While this could be dangerous, especially since the management could be overestimating the AI revolution, given that GOOGL has both the least subjectivity score as well as the largest decline in subjectivity towards the end of FY24 suggests that Sundar Pichai and Co. have taken a more measured approach towards their AI plans.

What should, however, be concerning for GOOGL investors is the rapidly declining polarity scores of GOOGL compared to its peers. This suggests that the GOOGL management’s sentiment has turned negative with each quarter. The rapid decline in the polarity score in Q4 from Q3 (-14.71%) is the highest among the three hyperscalers. This could be due to the higher uncertainty surrounding the Google Cloud’s revenue growth going forward, and the uncertainty surrounding when the company could bring more capacity online.

The results of the sentiment analysis should concern GOOGL’s investors, not only because Google Cloud is lagging its peers, but also given the company’s massive capex spend. A declining positive sentiment and a declining confidence are not what investors need from any of the hyperscalers right now. Unfortunately GOOGL management seems to be projecting both of these today.

The company continues to be the cheapest among the “Sensational Six” (GOOGL, AMZN, META, MSFT, AAPL, NVDA), currently trading at a forward P/E of 19.56x according to LSEG Data. It also continues to trade cheaply relative to its own historical multiples of 21.6x (5-year historical median forward P/E) and 22.5x (10-year historical median forward P.E). The median forward P/E multiple of the Sensational Six stands at 28.6x, lower than my previous estimate of 31.1x. This is not surprising given that these stocks have had a lacklustre start to the year. Given that NVDA belongs to a different sector, I am dropping the company from Alphabet’s peer list, which takes the median P/E multiple to 28.2x, once again lower than my previous estimate of 31x.

In my last article on Alphabet, I had assumed a forward P/E of 22.4x for my calculations, which was its 5-year historical median forward P/E at the time. I am maintaining this multiple for my calculations this time despite it being significantly lower than median P/E multiple of its peers. I believe this to be a reasonable assumption since the competitive landscape continues to remain challenging and given that FY25 appears to be a year of investment for the company, as evidenced by the $75 billion in projected capex spending. Moreover, management announced that there would be significant variability in Cloud revenue growth and some of the tailwinds that the company experienced in FY24 are not going to be there in FY24 (for example, Election-related advertising). So, considering all these factors, I believe a forward P/E of 22.4x is a reasonable estimate for my calculations.

A comparison of forward P/E of GOOGL and its peers

The consensus EPS estimate for FY25, according to LSEG Data, stands at $8.94, significantly lower than my estimate of $11.11. The difference in these estimates can be attributed to the fact that I assumed a y/y EPS growth of 34.8% for FY25 whereas according to consensus estimates, the projected EPS growth rate in FY25 stands at 11.6%.

Alphabet has a track record of consistently beating analyst estimates of EPS, with the company beating EPS estimates in four of the last five years (FY22 being the only outlier), albeit the margin of the beat has decelerated in the past couple of years. On average, the margin of the beat has been 2.90%. Due to the margin of the beat being well below my estimates and being the lowest margin in the last five years, this average is significantly lower than my previous estimate of 4.05%.

A screenshot of the comparison of earnings surprise of GOOGL in the last five years

I have adjusted my expectations appropriately and now project Alphabet to beat analyst EPS estimates by 2.90%, which would result in a projected FY25 EPS of $9.20. This translates to a y/y growth of 14.4%, lower than the company's long-term average growth of 19.8%. This is a more reasonable estimate in my opinion given that FY25 is expected to a year of investment due to the capacity constraints that the company has been facing.

A screenshot showing the average earnings surprise of GOOGL in the last five years

A forward P/E of 22.4x and a projected FY25 EPS of $9.20 would result in an updated price target of $206. Although this is significantly lower than my previous PT of $248, it still represents an upside of about 15% from current levels. Given the significant upside, while I am downgrading my rating on the stock from a STRONG BUY, I am still maintaining a BUY rating.

Risk Factors

In addition to the macroeconomic shocks such as FX headwinds, the other risk factor to my bull case would be the timeline of the return on the massive investment that the company has pledged towards capital expenditures. The $75 billion number was a surprise but is not uncharacteristic given that all of GOOGL's peers are also spending. But therein lies the problem. With an increasingly competitive landscape, and with Google Cloud continuing to trail behind Azure and AWS, investors have to factor in the scenario where the return on investment may take longer for GOOGL compared to its peers. This would subsequently impact my EPS growth estimates, should it transpire.

Concluding Thoughts

Alphabet ended the year with a mixed quarter, with revenues missing and EPS exceeding estimates. Despite the Cloud segment registering a strong performance, both the y/y growth in both revenues and operating margins declined. Furthermore, during the earnings call, the management, while announcing a massive capex spend of $75 billion for FY25, warned that there would be continued variability in cloud revenue growth as the company attempts to bring more capacity online.

A sentiment analysis of management remarks shows negativity creeping into GOOGL’s management, relative to its peers. This should be concerning to GOOGL investors, especially since Google Cloud continues to lag behind its peers and given the massive capex spend announced by the management.

The only silver lining is that the stock has been beaten up so much since the earnings report that it continues to remain attractive at current levels. As such, I have still maintained a BUY rating on the stock, albeit with a reduced price target.

Despite being attractive at current levels, given the declining sentiment of GOOGL management, with each passing quarter, relative to its peers, caution is certainly warranted.