Few doubt that 2025 will be another huge year for AI, but when looking for interesting investment opportunities, investors can sometimes allow details to obscure the bigger picture. In our view, Alphabet (GOOG:NASDAQ) remains an outstanding growth business with strong AI levers to pull, currently trading a large discount to other ‘Magnificent Seven’ stocks.

This valuation gap will, we believe, narrow over the coming 12 months as sentiment improves and growth outperforms, triggering significant share price upside. A PE (price to earnings) re-rating to just 25 would put $255 on the table in 2025, and that’s without any increase to current forecasts, implying material upside.

There are wild cards going into 2025. The impact of generative AI on the internet search advertising business remains a key issue for investors, while the outcome of antitrust lawsuits filed by the Department of Justice remains a ‘known unknown’, to paraphrase former US Secretary of Defence, Donald Rumsfeld.

ANTITRUST THREAT

The lawsuit, originally filed in 2023, comes after a combined investigation by the US government and more than a dozen states. The case focuses on a $31 billion component of Alphabet’s Google ad business responsible for placing banner ads on millions of websites, called Google Admob.

It’s a big deal. Search, which includes Google Admob, is Alphabet’s crown jewel, generating $237.9 billion of revenue in 2023, about 77% of its $307.4 billion total. For context, Google Play and Google Cloud produced $34.7 billion and $33.1 billion respectively last year.

Even so, the risk of a full break-up of Alphabet already seems to have been avoided following discussions with the DoJ in the hope that remedies can be found. The ruling by judge Amit Mehta was characterised as ‘measured’ by the antitrust lawyer that Piper Sandler analysts have spoken to, with findings of monopoly power in Search and General Text Ads but without evidence of consumer harm.

‘A break-up or forced divestiture of Android/Chrome is unlikely,’ according to Piper Sandler’s legal expert.

Fighting off legal challenges goes hand-in-hand with defending its patch in Search, but progress is being made. Alphabet’s Google began deploying ‘AI Overviews’ in the US in mid-May 2024, with conversational summaries topping links for many search queries. In late October, Google launched AI Overviews in 100 countries.

The AI Overviews system uses Google’s in-house Gemini AI model, and early indicators suggest advertisers utilising Gemini AI tools see increased traffic and click-through rates, especially among younger demographics, Google says.

Based on a survey, Evercore ISI analyst Mark Mahaney estimates no notable slide in Google’s share of internet search, indicating that: ‘Google’s generative AI innovations are creating an overall better search engine for users, which should translate into consistently robust search revenue for Google,’ he said.

AI, CLOUD AND OTHER BETS

Cloud infrastructure is another AI lever Alphabet is pulling. It’s Google Cloud arm remains the world’s third largest cloud computing infrastructure operation worldwide, behind Amazon’s (AMZN:NASDAQ) AWS and Azure of Microsoft (MSFT:NASDAQ).

Worries that huge AI investment might eat into profit margins also looks off the mark, quite the opposite in fact. Alphabet’s third quarter operating margins increased from 28% to 32% even in the face of elevated AI capital expenditure.

‘Alphabet generated free cash flow of over $17 billion, more than a third in excess of the total capital expenditures,’ said Gerrit Smit, who holds Alphabet in the Stonehage Fleming Global Best Ideas Equity Fund (BCLYMF3) he runs.

Significant ‘other bets’ include its autonomous vehicle rideshare service Waymo, and its developments in quantum computing, where Alphabet recently unveiled spectacular results from its new ‘Willow’ chip. The Waymo One robotaxi service already makes 150,000 trips a week in Phoenix, San Francisco, and Los Angeles, with expansion plans for Austin, Atlanta in 2025, and Miami in 2026.

Waymo is widely viewed as the leader in autonomous vehicles, and in October 2024, closed a $5.6 billion funding round. Wall Street analysts do not include Waymo, or any of its Other Bets in Alphabet’s valuation, and doing so would be a big development.

Put simply, Alphabet remains an astonishingly successful business and stock, with returns on capital and equity of more than 30%. Total returns stand at 22.3% a year over the past decade, a third better than the S&P 500.

Having weathered a year of significant pressure, and yet still advanced 40% year-to-date, we say Alphabet shares are worth buying for 2025. 

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