Alphabet (GOOG +1.53%)(GOOGL +1.74%) stock reached a new all-time high earlier this year on confidence in its broad tech platform and artificial intelligence (AI) advances. It even boasts a major investment from Berkshire Hathaway's Warren Buffett and Greg Abel, who have recently made it one of the conglomerate's largest equity positions.
However, the market's confidence was tested when Alphabet raised its outlook for capital expenditures this year after the second quarter. It now expects to spend $195 billion to $205 billion, up from an earlier estimate of $180 billion to $190 billion.
Alphabet stock plunged after the report, which was otherwise quite impressive, and it's now 16% off its high. Is this a plunge to buy into?
Staying on top of AI
The market ran from Alphabet stock in the period after OpenAI's first release of ChatGPT, when it appeared that the new large-language model (LLM) would make Google's search engine obsolete. But Alphabet immediately went on the offensive, developing its own competing LLM, Gemini, and adding its responses to the top of nearly every Google search. It regained its footing in search, and it now boasts a robust and diverse AI platform that it offers to search users as well as cloud clients.
Alphabet CEO Sundar Pichai. Image source: Alphabet.
To stay competitive at this point, it has to maintain that dominance, and the only way to do that is to spend. CEO Sundar Pichai and CFO Anat Ashkenazi both mentioned several times on the second-quarter earnings call that demand for AI infrastructure and solutions is outstripping supply, and that Google needs to expand to meet the growing demand. They both reiterated that they expect solid returns on investment.
"There are very, very large customers of ours on Cloud who ‑‑ we are trying to support them through this extraordinary moment," Pichai explained. "And the incremental opportunities they are bringing to us, while a short‑term cost over a few months may be very high, in the lifetime of the deal, as we bring more capacity on, is highly ROI‑positive."
The main issue the market has with this approach is that the company isn't bringing in enough cash flow from its operations to fund its data center build-out, so it's taking on more debt and selling fresh equity to do so. The company was free-cash-flow negative in the second quarter, and management said that its cash flows would remain under pressure while it invests for the long term.
Buying opportunity?
At the current price, Alphabet stock trades at a P/E ratio of 17, just off its lowest valuation ever by that metric. It looks like a buying opportunity rather than a value trap because the company has demonstrated solid fundamentals over many years, remains at the top of several industries, and has a path toward becoming cash-flow positive again.
It reported an 82% year-over-year increase in cloud revenue in the second quarter, driven by AI-related demand. The Google cloud backlog grew by $50 billion sequentially from the first quarter to $514 billion, and management says it will recognize half of that backlog as revenue over the next two years.
I'm not sure how soon Alphabet stock will recover from this slide and get back to setting new highs, but if you're playing the long game, you should expect it to create long-term shareholder value.
