THE FINANCE GHOST: The AI to Z of Alphabet’s challenges

With a share price drop of 14% year to date, Alphabet (the parent company of Google and YouTube, among many other businesses) hasn’t escaped the equities sell-off in response to tariffs and recession concerns. In fact, Alphabet has been hit considerably harder than the Nasdaq-100, the index associated with tech stocks, which is down “only” 7.4% over the same period.  Why is that? 

When consumer confidence takes a knock and economic growth slows, advertising budgets tend to shrink as well. This obviously has a direct impact on Google’s business, which is funded primarily by advertisers who put sponsored ads on the search engine itself and on the broader network of websites that show Google Ads. Even YouTube, arguably the most interesting business within the Alphabet stable, is far more reliant on ads than on YouTube Premium subscriptions — for now, at least. Compared with a big tech player such as Microsoft, which enjoys a vast enterprise customer base and recurring subscription revenues, Alphabet is vulnerable. 

Bulls would quite correctly point out that there’s far more to Alphabet than just advertising revenue. YouTube, now 20 years old, feels like a genuine wide-moat business in the Alphabet stable. TV is the primary device for YouTube viewing in the US. YouTube Music and Premium have more than 125-million subscribers, so there’s still plenty of growth if we use Netflix (more than 300-million subscribers) as a reasonable proxy.

The proliferation of smart TVs and fast, affordable internet creates the opportunity for YouTube. The success of the business is ensured by the incredibly wide range of user-created content for practically every niche interest you can think of, tapping directly into the human need to find and build communities around a common interest or trait. Though advertising revenue got YouTube to where it is today, subscription revenue will help drive it in the future.

In the cloud space, Alphabet is building a subscription-based business that focuses on infrastructure and workspace application products. That infrastructure certainly comes at a cost though, with immense investment in data centres and other areas driving a rapid increase in the depreciation costs in the group. Depreciation grew 31% in the latest quarter and the group expects an acceleration this year thanks to the capex that has already happened, let alone capex that could still come down the line. If cloud demand turns out to be disappointing — due to a recession, for example — then this could do significant harm to margins. 

So, yes, there are non-advertising businesses in the Alphabet stable, but they aren’t at the point yet where they can replace advertising revenue. This means that the AI trends around search are extremely relevant. One of the biggest risks facing Alphabet is that AI — both at competitors and in Google’s own ecosystem — is disrupting the search business. 

How often do you actually go to underlying websites these days when you search something? Despite Google assuring website owners that the AI-generated answers (called AI Overviews) in response to a search query aren’t affecting website visits, we all know that this is complete nonsense. Just consider your own behaviour online when searching for information. 

But what choice does Google have? It’s so quick and easy to use the likes of ChatGPT and Grok instead of traditional search methods, so it simply has to move with the times by investing heavily in AI Overview. Though revenue in the search business was up 10% in the latest quarter, digging deeper reveals a trend that is going to change the internet ecosystem as we know it. 

Network revenues, earned through adverts shown on partner websites, are declining. This talks directly to the number of hits that websites are getting. AI is doing a wonderful job of repackaging people’s hard work into freely available, bite-sized chunks, without users needing to even go to the underlying website. Website owners who rely on Google Ads need to rethink their monetisation models if they hope to survive. This is especially true as Google prefers earning advertising revenue on its own platforms rather than through network ads, due to the impact on margins of having to pay commissions to website owners. 

But if website owners stop being paid, who will create all the new content that feeds the AI machine? This is just one of the many questions that are relevant here. The market knows that nobody has the answers right now, which is why the uncertainty about Alphabet’s business model, combined with recessionary fears, has driven the share price lower.