Alphabet-A

Alphabet reported strong second-quarter earnings, with the firm's sales growing 24% to $120 billion and its operating margins expanding 2 points to 34%. Google Cloud grew by 82% to $25 billion, with margins for the cloud segment also increasing by 15 points to 36%.

Why it matters: Alphabet continues to show real progress in artificial intelligence monetization. As investors seek to understand the returns on massive AI-driven data center spending, we believe returns are showing up for Alphabet across its primary segments. The clearest signal of booming AI spending is found in the Google Cloud segment, with the backlog, or contracted future revenue, increasing to $514 billion, up from $108 billion a year ago. Beyond cloud, we are seeing continued strength in Search, with Google Search growing 17%. Encouragingly, Alphabet's push to an AI-native search experience is seeing good adoption, with AI Mode's monthly users exceeding one billion.

The bottom line: We maintain our $433 fair value estimate for wide-moat Alphabet, and continue to view its AI monetization across chips, infrastructure, models, and applications as a great way for investors to gain AI exposure without being limited to a specific part of the AI stack. Alphabet shares are trading down after hours, likely due to investor concern about the firm's rising capital expenditures, which are expected to exceed $200 billion in 2026. We'd position investor attention on the real returns the firm is generating from its large AI investments, including significant growth in its cloud business and core advertising business. We model continued acceleration as the firm's hardware sales inflect upward in 2027.

Key stats: Alphabet's free cash flow turned negative this quarter, a trend we expect to continue in the coming quarters as the firm ramps up its AI investments. As mentioned above, we believe investors should focus on the AI demand story, which supports such large capital expenditures.

Alphabet's multivector AI monetization strategy allows the firm to benefit from AI spending, even if its own AI models are not as widely used or popular as those from other labs. A clear example of this dynamic playing out is Anthropic leveraging Alphabet's TPUs, or AI accelerators, and Google Cloud to train and run inference on its models. Alphabet's partnership with Anthropic across the chips and infrastructure layers positions it to benefit from increased spending on Anthropic's models, as evidenced by the rapid growth in both Google Cloud revenue and backlog.

That said, we estimate that Alphabet's first-party Gemini models' API usage likely contributed around 15%-20% of the total Google Cloud business. We believe that while top coding models, such as Fable 5 and GPT 5.6, receive significant investor attention, low-latency, efficient models are key to growing AI usage across enterprises, an area of clear focus for Alphabet.

As we zoom out and look at Alphabet's historical performance as a business, one trend is clear: Alphabet, as a business, is incredibly talented at infrastructure optimization or driving the cost of infrastructure down to the point where the firm clearly has a cost advantage over almost all of its peers.

We have seen multiple pieces of evidence that Alphabet is attempting to follow a similar infrastructure-optimization path for AI. The firm's AI chips, TPUs, already provide it a lower cost basis for training and running inference on large models versus providers leveraging GPUs. Beyond TPUs, the firm is pursuing a co-design approach that includes loading parts of the language model onto a hardware chip, thereby reducing the compute costs associated with running language models by orders of magnitude.

Further, the firm has been investing in architectural and algorithmic changes to make its AI models cheaper to serve, which is key for a company like Alphabet, which has many applications with AI features (Search, YouTube, Maps, Chrome) that serve billions of users. By making its infrastructure optimized to deliver AI inference at scale, Alphabet could also unlock further opportunities to work with enterprises or AI model companies that are seeking to drive down their costs to serve as well.

Finally, Alphabet's Gemini has all but closed the gap on OpenAI's ChatGPT as a consumer-facing AI app. Gemini's monthly users grew to 950 million, up from 450 million a year ago. This growth, coupled with the 1 billion-plus users for AI Mode, indicates that Alphabet will be able to control a large chunk of the consumer AI mindshare. Longer-term, we see the firm's Gemini and Search experiences enabling it to improve its ads business through ad personalization and a deeper understanding of the intent behind queries.

Our fair value estimate is $433 per share, implying a 2026 adjusted price/earnings multiple of 30 times and an enterprise value/adjusted EBITDA multiple of 26 times.

We forecast Alphabet’s top line growing at an 18% compound annual growth rate over the next five years.

Drilling deeper into the firm’s various segments, we expect Google Search to grow at a 10% compound annual growth rate over the next five years as the digital advertising market matures and growth rates taper off after a robust few years following the pandemic. We expect YouTube to grow at a low-double-digit rate over the next five years, with a strong advertising business being increasingly supported by a robust subscription business.

We view Google Cloud as a key growth driver for Alphabet’s overall business. We project Google Cloud sales to grow 47% annually on average over the next five years as cloud migrations, increased usage of AI, and additional software add-ons all work together to bolster the firm’s cloud sales. Alongside the firm’s public cloud business, we believe Google Cloud will also benefit from increased usage of Google’s Workspace productivity applications as the firm embeds more AI tools within them, improving their quality while attracting higher average revenue per user. Over the next five years, we expect Google Cloud to constitute around 43% of Alphabet’s overall top line, up from 15% at the end of 2025.

We foresee a slight expansion in Alphabet’s operating margins over the next five years. While the firm’s scale and improving Google Cloud margin profile should enable it to improve profitability, these potential improvements more than offset the higher depreciation costs stemming from massive capital expenditures on data centers and AI capabilities. We expect Alphabet's overall operating margins to approach 35% over the next five years, up from 32% in 2025.

As we model the trajectory of Alphabet’s future revenue growth/profitability, we also look at a hypothetical bull case.

The bull case envisions a scenario where Google Search maintains its dominance in the online search market while the video and cloud business continues to fire on all cylinders as AI adoption accrues material benefits to the firm with little AI-led disruption. Our fair value estimate in the bull case is $500 per share.

We also look at valuing Alphabet using a sum-of-the-parts approach. Using SOTP, we arrive at a $468 fair value estimate. While the majority of Alphabet’s enterprise value continues to be driven by advertising, with Google Search being the largest advertising segment, we see a lot of potential value in other areas of Alphabet as well. According to our SOTP valuation, Google Cloud constitutes nearly 40% of the firm’s overall intrinsic value. YouTube ex ads, Play, and hardware sales, along with Waymo, combined make up 13% of Alphabet’s total value.

We believe Alphabet merits a wide economic moat rating owing to the intangible assets, network effect, cost advantage, and customer switching costs that permeate a variety of businesses that it owns.

While Alphabet’s own reporting operating segments are split into Google services, Google Cloud, and other bets, we believe that for the purposes of analyzing the firm’s economic moat and durable competitive advantage, a different split is more appropriate. In our moat analysis, we look at Google Search, YouTube, Google Cloud, Android and Google Play, devices, and other bets (which includes Google’s aspirational projects such as self-driving vehicles and internet access).

Google Search

We assign a wide moat rating to Alphabet’s premier offering, Google Search. This general search engine has built significant intangible assets, primarily via its brand, and a potent network effect that allows Alphabet to be the dominant player in the GSE space, with an engaged audience of both users and advertisers.

Google Search’s dominance cannot be overstated. The firm’s search engine has garnered and maintained ubiquity in the internet era to the degree that Merriam-Webster recognizes “google” as a verb that is interchangeable with search. Over the last two decades, Google Search has cemented its place as the most advanced GSE on the market, controlling more than 80% of the general search market since 2009. Market share shoots past 90% when looking at only mobile devices.

Google Search’s intangible assets are related to the firm’s brand, the general recognition of its GSE as the most advanced out there, and technological expertise when it comes to search algorithms, pricing mechanisms, and gathering valuable data for its advertising client base. Google Search’s intangible assets also bolster its network effect. As more users engage with Google Search on account of its search superiority, it can monetize those users by selling better ads, which then allows the firm to invest more in Google Search to improve its GSE, while also collecting better signals for its advertising clients.

Google Search simultaneously solves two key problems for its main stakeholders, users and advertisers. A user wants access to high-quality information in a fast, seamless manner. Google provides this by keeping its products free and by constantly adding more functionality to its offering, such as live sports scores, shopping and travel tabs, and multimodal search options, among other features. Google collects various signals a user provides, such as clicks, time spent on a page, and time spent hovering over a link, to inform its advertising business, which sells real estate on the Google Search results page to advertisers.

Advertisers, on the other hand, want users to purchase their products/services. They have a finite amount of dollars to drive these sales and care deeply about the return on ad spending, or ROAS. When a user searches for a specific keyword, such as “QLED Television,” on Google Search, there is a high likelihood that the user is interested in buying a TV. In advertising nomenclature, by searching for a specific keyword, a user has signaled their intent. By getting ads in front of this hypothetical user, advertisers can convert the intent of the user into action, the purchase of a TV. As a result, Google Search is a core part of almost every digital advertising campaign, underscoring the high ROAS advertisers are able to generate via Google Search.

Alphabet has successfully monetized its Google Search offering, with the firm generating tens of billions of dollars in profits annually. We believe the firm’s monetization also betrays a true sense of pricing power that stems from its intangible assets and network effect. By using a modified version of a second-price auction model, Google Search conducts auctions of the real estate on its main display page, with advertisers bidding on specific keywords. The auction itself is conducted in the milliseconds between a user search and the resulting display of results. Google has leveraged a series of “intentional pricing” maneuvers to increase bids and generate additional sales from its search engine. With its main competitor, Microsoft Bing, struggling to attract a critical mass of users, Google exercises significant pricing power in the general search market.

Google Search’s dominance within the search market is also bolstered by a series of exclusive contracts Alphabet has signed with device manufacturers, such as Apple and Samsung, and third-party browsers, such as Mozilla Firefox. While these exclusive contracts are subject to increased regulatory scrutiny, they continue to channel significant traffic to Google Search, with approximately 50% of all general search inquiries in the United States stemming from a search access point covered by an exclusive contract. Alphabet, in return, offers a portion of its advertising revenue generated by these search points via a revenue-sharing agreement. While antitrust pressures may threaten Google Search’s hold on the general search market, we don’t believe there exists a scenario where an antitrust remedy pushes Google Search’s returns on invested capital below its cost of capital.

When thinking of Google Search’s placement as the default search engine for Apple and Android devices, it is important to delineate between the impact of default settings and Google Search’s own product capabilities that bring users to its GSE by choice. One helpful illustration of the latter can be found in the PC market. While the majority of PCs in the world carry the Windows operating system, which has Microsoft Edge preloaded, the vast majority of Windows users opt to install Google Chrome and leverage Google Search instead of using Bing on Microsoft Edge.

Other competitive threats to Google Search come from specialized vendors such as Amazon, Meta, TikTok, and Yelp. While Alphabet certainly competes with all of the above in various verticals such as retail and travel, Google Search’s dominance in navigational queries (queries to go to a specific website) and the general search market is unfazed by these specialized vendors. We also see them as competing in a slightly different market, with no reasonable user viewing Google Search and Meta as substitutes, for example. Similarly, advertisers view specialized vendors such as Amazon and Meta as complementary to ad spending on Google Search, with text-based ad budgets often controlled by different teams than Amazon/Meta ad placements.

Also, while generative search engines, such as SearchGPT by OpenAI, threaten to upend the general search market, we don’t see those competitive threats resulting in a material deterioration of Google Search’s excess returns. Irrespective of whether the new entrant is a well-capitalized player such as Apple or a venture-backed startup, the costs of building a GSE are cost-prohibitive. The new entrant has to build the infrastructure to support a GSE, which requires billions of dollars, while simultaneously attracting users and advertisers. After the initial infrastructure and customer acquisition, the entrant then needs to spend billions of dollars maintaining the GSE and investing in new capabilities such as better ad targeting, signal collection, and data storage. All of these costs, in sum, provide a structural barrier to competition for Google Search, which has scale that allows for cost-effective exposure to a large set of users and advertisers. Further, we believe Google’s own generative AI offerings, such as Gemini, can avert any major customer/advertiser churn.

YouTube

We assign YouTube a wide moat rating owing to the business’ strong network effect and intangible assets. Wrapped within Alphabet, YouTube is a streaming giant with an impressive brand, user base, and burgeoning advertising and subscription businesses.

YouTube, acquired by Alphabet in 2006, is one of the largest video-sharing/streaming platforms in the world. YouTube’s scale is staggering. The platform has more than 2 billion monthly users with 1 billion hours of YouTube content viewed daily on TV alone. YouTube has parlayed its ubiquity to enter the subscription business as well. The platform’s subscriptions, including YouTube Music and YouTube Premium, have more than 100 million subscribers, while YouTube TV, an offering that resembles the traditional TV bundle, boasts more than 8 million subscribers.

We believe YouTube's intangible assets, such as its large monetizable user base and brand, bolster its network effect. The platform’s massive audience attracts creators seeking to monetize their videos, which, in turn, fuels more watch time. While more than 99% of YouTube’s user base consists of free users, these users are critical for the platform’s ad sales. By running a profitable advertising business, YouTube is able to invest in content, such as the seven-year deal to host the NFL Sunday Ticket, and boost its subscription offerings such as YouTube TV.

YouTube also offers Alphabet access to the top of the marketing funnel, allowing companies to create brand awareness that can spark a desire and intent to purchase a product. As a result, YouTube is a key part of Alphabet’s overall advertising business as it is able to reach users in a medium very different than text-based search.

While the market landscape for YouTube is considerably more competitive than Google Search, we believe the firm’s impressive ability to expand its reach across devices (phones, TVs, desktops) and its ability to innovate (creation of YouTube Shorts) should allow it to profitably run its platform and generate returns in excess of its cost of capital for the foreseeable future.

Google Cloud

While Alphabet’s operating segments lump Google Workspace (productivity applications like Google Drive, Sheets, and Docs) together with Google Cloud Platform, we estimate that the vast majority of sales within Google Cloud stem from GCP, Alphabet’s public cloud infrastructure arm. As a result, when investigating the competitive advantage for Google Cloud, we focus primarily on GCP.

We believe GCP merits a wide moat supported by high customer switching costs and cost advantages. While the Alphabet’s public cloud platform is markedly smaller than Amazon’s AWS or Microsoft’s Azure, it is the third-largest public cloud vendor, controlling more than 10% of this lucrative market.

The cost advantages of GCP are obvious. The firm’s continued investments in its cloud infrastructure, including AI, have enabled it to be one of three firms that have a global public cloud footprint. As compared with a customer building out their private cloud infrastructure, GCP, much like AWS and Azure, offers a significantly cheaper route that is analogous to renting real estate on GCP, helping the customer avoid massive capital expenditures associated with a private data center buildout. Further, as Alphabet has continued to invest in GCP, the economics of the business have improved dramatically. After generating substantial losses in prior years, GCP has turned profitable, with improving profitability on the horizon. As the firm expands its customer base, by typically offering better prices than AWS and Azure, it can continue to spread costs across its data center footprint, allowing its existing cost advantage to get stronger.

Another source of GCP’s cost advantage has been Alphabet’s investment in its own proprietary semiconductors, its TPU, or tensor processing unit. In lay terms, TPUs are custom-designed AI accelerators that can be leveraged for training and inference in the context of large AI models. While customers of GCP can opt to use third-party GPUs for their AI-related cloud workloads, all of Google’s own AI development, such as the development of large language models, is done exclusively on its own TPUs. This represents a cost advantage over other peers using third-party GPUs to train their LLMs. While Microsoft and Amazon have been investing in their own AI chips, similar to Alphabet’s TPUs, smaller public cloud vendors and customers choosing between public cloud or building their own data centers will likely remain cost-disadvantaged against GCP in this regard.

We also believe GCP benefits from high customer switching costs. Porting workloads from on-premises to the public cloud is not an easy lift, often requiring companies to rewire their IT infrastructure to allow for the transfer. This digital transformation is fraught with handover risk and cumbersome change management. Once a company, typically a large enterprise, has rolled into GCP, the costs of leaving GCP are significant. While data egress fees have been coming down throughout the public cloud space, the time and expense of application and database integrations have not. Similar to AWS and Azure, we think that the likelihood of customers changing mission-critical technology infrastructure is low. For context, when forecasting GCP’s growth, we don’t forecast AWS or Azure being customer donors to GCP, showcasing the high switching costs associated with public cloud vendors.

Android and Google Play

We believe Alphabet’s Android operating system and Google Play, its application store present on all Android devices, enjoys a wide moat stemming from intangible assets and a network effect.

Android is the operating system for the majority of the world’s smartphones, with more than two-thirds of all smartphones in the world running it. Virtually all smartphones, other than those manufactured by Apple, run on Android with the smartphone operating system space functionally a duopoly.

We believe Android and Google Play’s intangible assets stem from the deals Alphabet has made with all smartphone manufacturers using Android as the default operating system. These deals, known as mobile application distribution agreements, allow smartphone manufacturers to use Alphabet’s proprietary mobile applications that it has developed for the Android ecosystem. One of these proprietary mobile applications is Google Play, the app store that allows Android users to download non-preloaded applications such as Facebook or Spotify. In exchange for providing its applications, including Google Play, Alphabet gets prominent product placements for its applications, many of which are monetizable via advertising such as the Google Search widget, YouTube, and the Chrome internet browser.

While these contracts are being challenged in courts as anticompetitive, final judgments remain far out in the future. We think that even if Alphabet is forced to open up its Android ecosystem by allowing smartphone manufacturers to leverage its applications on a different operating system, the successful entry of a new player in the operating system market is hard to envision.

The difficulty in creating an operating system is not simply tied to the expenses associated with engineering talent. The most crucial part of an operating system is its ability to connect its users to a wide range of applications beyond the ones that come preloaded with the device. This is where the network effect created by Google Play really shines.

Developers, from large companies and small, all know a basic truth: undertaking the costs of developing an application is only worth it if you can monetize the application by putting it in front of a large audience. The audience, in the case of smartphones, is almost exclusively controlled by Apple and Alphabet. This creates a virtuous cycle of developers working tirelessly to develop high-quality, bug-free applications for Android and iOS, which in turn attract more usage on these applications as users download them via Google Play and the App Store.

For a new entrant to enter the operating system market and compete with Android and Google Play, the entrant would have to simultaneously attract a critical mass of developers and users, neither wishing to enter a space that is not already populated by the other.

From a return on invested capital perspective, Android and Google Play are lucrative businesses. For every sale on Google Play, Alphabet collects a fee from the developer. This fee, after accounting for the cost of running Google Play, is likely incredibly lucrative from an operating margin perspective, indicating positive excess returns on the business unit. Similarly, the mobile application distribution agreements that Alphabet currently has with smartphone manufacturers include prominent placement of its own applications, serving as a funnel to its high-margin advertising business, which implies a high return on invested capital when it comes to operating and keeping Android up to date.

Devices

We believe that Alphabet’s hardware portfolio, which includes the Pixel and Nest group of products, Chromecast, and Fitbit, does not merit an economic moat as a stand-alone business. This is primarily due to the lack of any material disclosure that would allow us to ascertain the business’ profitability and returns generated.

While Pixel smartphone sales have shown strength over the last few years, including a surprising pocket of strength in Japan, where the smartphone constitutes roughly 10% of the overall smartphone market, we don’t have a reliable method to determine the returns on the firm’s invested capital in this space. We won’t be surprised if Alphabet’s hardware portfolio is generating excess returns and can see an argument for the presence of an economic moat, not too dissimilar to those built by other smartphone manufacturers, yet the obfuscation of granular data, an operational hazard when it comes to conglomerates such as Alphabet, precludes us from building a robust argument for an economic moat.

Other Bets

While Alphabet’s other bets portfolio includes some interesting companies, including Waymo, which is one of the leaders in autonomous vehicles, the segment continues to burn capital, generating returns well below its cost of capital. As a result, we ascribe a no-moat rating to Alphabet’s other bets business.

We believe that as some of the technologies Alphabet has invested in mature, they could spin off to be stand-alone businesses or perhaps be a larger part of the Alphabet story. We have particularly high hopes for Waymo, which has consistently shown promising results and progress in the AV market. We also understand that Alphabet, as a large incumbent, continues to invest in aspirational technologies such as Waymo as a way to be at the forefront of technological innovation. At the same time, however, there is considerable uncertainty as to whether any of Alphabet’s aspirational investments will be economically successful.

Alphabet’s core advertising business is deeply entrenched in advertising budgets, allowing the firm to benefit from a secular increase in digital advertising spending

The firm’s advertising business generates substantial cash flows that it can reinvest in growth areas such as GCP, AI-infused search, and aspirational projects such as Waymo.

Alphabet has a huge opportunity in the lucrative public cloud space as a key cloud vendor to enterprises looking to digitize their workloads.

While Alphabet is seeking to diversify its business away from search, text-based advertising remains the largest contributor to the firm’s top line, creating a concentration risk.

Alphabet’s continued investments in new, often unproven technologies have been a drag on cash flows.

Regulators around the world are keying in on Alphabet’s search dominance and could upend the search market through the imposition of deep, structural changes in the space.