One of the most closely followed investors on Wall Street is Bill Ackman, the CEO of Pershing Square Capital Management. Last year, it was revealed the hedge fund manager opened a position in Alphabet (GOOG +2.66%) (GOOGL +2.81%), the parent company of internet search tool Google and video sharing platform YouTube.
Ackman's investment strategy is quite simple. While other institutional investors tend to own several stocks in each sector, Ackman instead identifies a small cohort of businesses that he believes are overlooked and potentially undervalued -- making it easy to understand which stocks he appreciates over the competition. For this reason, Ackman's stake in Alphabet represented something greater than just a new position. Rather, it signaled his conviction in the company's position among artificial intelligence (AI) leaders. But why?
During a recent interview with David Rubinstein, a co-founder of private equity giant Carlyle, Ackman revealed that he thinks investors can buy Alphabet's AI business "for free." While this is quite the conjecture, I think he's right.
Let's dig into why Alphabet might just be the most overlooked AI stock among the "Magnificent Seven."
NASDAQ: GOOGL
Key Data Points
Alphabet's advertising business faces headwinds...
At its core, Alphabet is an advertising business. Given that Google and YouTube are the world's top two most-visited websites, it's easy to comprehend why advertisers flock to these platforms. Moreover, with Alphabet's surface area online, the company can command strong pricing power from customers.
This business model has historically resulted in strong revenue growth and, more importantly, robust margin expansion for Alphabet. However, the last couple of years haven't gone so well for the company.
For starters, the macroeconomy was plagued with high inflation, thereby causing the Federal Reserve to raise interest rates nearly a dozen times. As a result, businesses of all sizes reined in spending and operated under tighter budgets. Very few businesses were immune to these dynamics, and the already cyclical advertising sector was no exception.
In addition to broader market dynamics, Alphabet's advertising operation also faces increasing competition. The popularity of social media app TikTok, combined with other major players such as Meta (which owns Facebook and Instagram), put Alphabet in a tough spot. In fact, Alphabet's advertising revenue in the fourth quarter of 2022 actually declined on a year-over-year basis, spooking investors about the company's prospects.
However, perhaps its biggest challenge comes from Microsoft. The Windows developer arguably kicked off the artificial intelligence (AI) arms race early last year following a $10 billion investment in OpenAI, the start-up behind ChatGPT.
Microsoft's perceived first-mover advantage in AI, coupled with intensifying competition and a tough economy, had many investors questioning how dominant Alphabet's future within Internet search and advertising may be. Unsurprisingly, the stock cratered nearly 40% in 2022.
Image source: Getty Images.
...and its AI pursuit appears overlooked
Although it can be easy to be persuaded by mainstream sentiment, long-term investors can often think beyond whatever crisis is currently taking place. Alphabet no doubt faced headwinds in its core advertising segment. But keep in mind, it's this business that fueled billions in free cash flow for Alphabet over the years and provided the company the financial fuel to invest in other areas.
While investors started to sour on Alphabet in 2022, the company remained focused and found ways to diversify its business -- namely through strategic acquisitions. The company's investment in cybersecurity infrastructure has played an integral role in the development of its cloud computing operation, which is taking on industry stalwarts Amazon and Microsoft.
In fact, the growth of Alphabet's cloud business has been a pillar in the company's AI pursuit. This is a big deal, and subtly underscores why Ackman sees Alphabet's AI business as free.
Is Alphabet's AI business really free?
Alphabet stock rebounded nearly 60% in 2023. Keep in mind, however, that the company only increased its total revenue by 7% year over year through Sept. 30. Perhaps what sparked renewed investor enthusiasm was Alphabet's return to growth in advertising. While encouraging, it's this dynamic that has me thinking investors are missing the bigger picture.
Alphabet's cloud segment increased sales by 26% year over year through Sept. 30, and it is now consistently generating positive operating income. Artificial intelligence (AI) applications are increasingly becoming integrated throughout Alphabet's cloud offerings, helping spark rising demand over the competition.
Moreover, Alphabet swiftly answered Microsoft's call and hasn't been shy about showing off its own AI capabilities. The latest installment from the company is its ChatGPT competitor, called Gemini. As Alphabet continues to integrate AI across its suite of productivity tools, cloud infrastructure, Google Search, and YouTube, more accelerated revenue and profit growth could follow.
Yet, as of this writing, Alphabet stock trades at only a 20.7 forward price-to-earnings (P/E) multiple -- nearly identical to that of the S&P 500. By contrast, Apple, which is experiencing declining revenue, trades at a forward P/E of 28, while Microsoft trades at 33 times forward earnings.
I think Ackman is right in that many investors appear to be completely overlooking Alphabet's AI progress -- not even realizing that it's AI that helped reignite the company's growth. To me, Alphabet's bargain valuation offers investors an opportunity to own a leading AI developer at a steep discount relative to the competition.
