On September 20, EU regulators issued an ultimatum to Google: If Google fails to address EU concerns in a timely manner and display competitors' products more prominently in its search services, Google will face a hefty fine of up to 10% of its annual global turnover and may be required to change its business model.
Against the backdrop of frequent antitrust cases and increasing risk of spin-offs, Google's valuation multiple has fallen to a historic low. Especially at a critical time when management is changing, how can Google seize this opportunity to regain investor confidence?
In this regard, Morgan Stanley analyst Charlie In his latest research report, Chan outlines three steps Google can take.
Google should increase information about generative AI and keep the pace of innovation
To help investors better capitalize on the new growth opportunities presented by generative AI, Morgan Stanley suggested that Google should provide more information, especially data on the growth of user engagement, revenue potential, and the effectiveness of the early adoption.
Such disclosures will help investors understand the sustainability of Google's capital expenditure growth and its revenue growth. Although Google has mentioned improvements in its advertising performance, the market needs more detailed data to assess the extent to which Google has adopted new technologies and products in order to accurately measure the specific impact of these advancements on its financial statements.
In addition, Morgan Stanley believes that Google should continue to innovate at a high rate and showcase emerging sources of innovation in its product line. Google has a large number of new products and tools in development, testing, and step-by-step deployment in various areas such as search, YouTube, and cloud computing. Considering that the impact of antitrust regulation could last for many years, Morgan Stanley believes that Google's ability to continue to develop innovative technologies and reach new users and advertisers is critical to solidifying its leading position in online channels.
Enhance investor confidence in Google's free cash flow
First, Google should provide specific guidance on AI capital expenditures and free cash flow. In the debate over the investment bubble in generative AI, the market is particularly focused on the growth of capital expenditures by large tech companies now and over the next two years. FOR EXAMPLE, META HAS ALREADY PROVIDED GUIDANCE ON FUTURE CAPEX, MICROSOFT HAS ALSO GIVEN CAPEX COMMENTS IN SUBSEQUENT QUARTERS, AND AMAZON HAS COMMENTED ON ITS FULL-YEAR CAPEX. In contrast, Google only said: "Looking ahead, we expect capital spending to be broadly flat or slightly higher than the $12 billion in each quarter of this year." This lack of clarity, coupled with Google's top management saying that "the risk of underinvesting is much greater than the risk of overinvesting", has led to a high level of uncertainty about Google's free cash flow (FCF).
Second, Google should quantify the benefits of further optimization of its operating expenses (Opex) and promise to improve profit margins. Over the past 20 months, Google has successfully implemented several workflow reforms, redesigned its OpEx structure, and leveraged it through strategic investments. These reforms have made significant progress, with Google's operating expenses increasing by about 6% and margins increasing by about 230 basis points in 2023. Compared to its internet peers, Google is in the middle of the industry in terms of operating expenses per employee, and close to the upper limit of the industry in terms of revenue per employee.
Finally, Google should issue quarterly guidance and try to raise its forecast. Many peer companies, such as META, Apple, and Microsoft, have issued quarterly guidance to help investors better understand the market dynamics and understand the reasonable range for future growth and profitability of the company. Some companies even offer annual guidance. By issuing guidance and raising its forecasts if necessary, Google will be able to increase investor confidence in its business operations, drive valuation multiples higher, and reduce valuation volatility.
Help investors understand key growth areas
First of all, Google should break down YouTube's ad revenue and subscription revenue. Currently, YouTube's ad revenue in 2023 is around $31.5 billion, and it is expected to grow by 12.5% year-over-year in 2024. However, YouTube's subscription revenue is less clear. Although Google has been driving the growth of YouTube's subscription business, investors can only speculate that its subscription revenue in 2023 will be around $15 billion due to limited disclosures.
Secondly, Google should also break down the Workspace and GCP parts of Google's cloud business. Currently, the total revenue of Google's cloud business in 2023 is approximately $33 billion, and it is expected to grow by 31% year-on-year in 2024. However, this number covers both the Workspace business and the faster-growing and more significant Hyperscale Cloud Computing (GCP) business. While estimates for GCP and Workspace are already in the market, ongoing and detailed disclosures will help the market better understand the competitive landscape between Google and AWS and Azure at this critical time for generative AI.
Morgan Stanley believes that greater transparency in this regard is not only a big opportunity for Google's valuation multiple, but also an important way for investors to better understand the return on capital expenditures.
