Why did Berkshire buy in at this time? Financing $80 billion to bet on AI, is it worth buying Google after the pullback?

According to Zhitong Finance APP, Google's parent company Alphabet (GOOG, GOOGL.US) recently announced a financing round of up to $80 billion aimed at raising funds for AI development, which includes a $10 billion investment from Berkshire Hathaway (BRK.US) at a price of approximately $350 per share.

Investors in Google reacted lukewarmly to the news of Berkshire Hathaway's investment, leading to a significant drop in stock price on Tuesday. It is not surprising that investors sold off after this news, as they may believe that Berkshire struck a lucrative deal at the expense of existing Google shareholders. However, when we examine how Google plans to use the raised funds, we find that this expenditure is likely to be worthwhile. It is not surprising that Google chose to issue new shares at this time. The company is in the midst of a large-scale AI buildout, and its stock price is not far from historical highs. It faces significant investment opportunities while its stock price is at a sharply rising high, which is a classic timing for issuing new shares for financing.

Therefore, Google and its shareholders are in a favorable position. This raises the question: how long can this feast last? While Google is undoubtedly a great company that will continue to excel for many years to come, its stock price has reached a level that few investors anticipated at the beginning of last year. Berkshire believes Google is worth investing in, but clearly, it is entering at a discounted price.

Purely based on price momentum, Google's rise may be unlikely to continue. Looking back at Google's significant gains over the past six months, one year, and five years, one might intuitively think that the stock is due for a correction. However, when examining Google's fundamentals, a completely different story emerges.

Google has strong profitability, with high profit margins and capital returns. For a company of its size, its growth rate is also rapid, with earnings increasing by 22% over the past 12 months. Despite such outstanding performance, the company's valuation remains low compared to its sector, with a price-to-earnings ratio of 29 times, while the NASDAQ 100 index has a price-to-earnings ratio exceeding 30 times. Therefore, whether based on historical performance or current value, Google appears to be a good choice.

As with any company, the challenge lies in determining whether Google's strong performance can continue into the future. Google is built on a strong and interconnected "ecosystem" of products and services, with several products having billions of users, which is the main driver behind its stock price soaring above $350. However, many changes are occurring in the current tech world, including intensified competition in the AI sector, which is the area Google is currently heavily investing in. Therefore, given the gains Google has achieved and the changes in its industry, the investment logic for Google also needs to be re-evaluated.

Analyst A.J. Button rated Google stock as "buy" on April 30, citing its steady growth alongside massive increases in capital expenditures (CAPEX). The high capital expenditures are the reason for his "buy" rather than "strong buy" rating. Since then, Google's stock price has declined. The current slightly lower price may present a buying opportunity, but on the other hand, competition in the AI investment space is much fiercer than in the search space a few years ago. Therefore, we need to be certain that Google is still the clear and undoubtedly worthy investment it was a few years ago

Google's Equity Financing

Since A.J. Button last published an analysis of Google, the first significant change that has occurred is that the company has issued new shares for the first time in years. The funds raised amount to a staggering $80 billion. Therefore, it is worth exploring what Alphabet has gained by diluting shareholder equity in exchange for $80 billion.

According to the press release announcing the allocation, Google plans to use this $80 billion for AI computing and infrastructure, which means data centers, servers, and other semiconductors are necessary to run Google's numerous AI applications. These applications include AI-integrated products (such as Search, YouTube, Google Drive) as well as Google Cloud, which sells computing power to third-party developers.

It is in the latter category of business that things start to get a bit complicated. Google Cloud is a relatively new part of Google's business, achieving profitability for the first time in 2023. It operates in a highly competitive field, facing significant challenges from competitors like Amazon (AMZN.US) AWS and Microsoft (MSFT.US) Azure. This is certainly not an "exclusive business" like Google Search, although it can be argued that Google Search still holds that status today.

Google competes with the aforementioned two cloud companies in selling AI servers to web developers. A significant portion of recent business has been selling the use of NVIDIA (NVDA.US) chips as a service. The cloud business also has a software component, such as hosting developer tools that developers can use to fully utilize the servers they rent, and there is some room for differentiation in this business. For example, companies can offer proprietary applications as developer tools exclusively on their own cloud. However, this space is certainly competitive, with three of the "Seven Giants" vying for the same business, and smaller players like Oracle (ORCL.US) and several Chinese companies are also trying to enter this field.

So far, despite the competition, Google's cloud division still seems to be profitable. In the most recent quarter, the division's operating profit was $6.5 billion, a year-on-year increase of 200%, which is undoubtedly a positive sign. However, the company also experienced a quarter-on-quarter decline in free cash flow during the same period, with first-quarter FCF lower than fourth-quarter FCF of the previous year. This is primarily due to massive cash outflows caused by AI construction, with Google estimating that capital expenditures for the full year 2026 will be between $180 billion and $190 billion. The company's earnings remain robust, but its cash flow performance is quite volatile, showing year-on-year or quarter-on-quarter declines in recent quarters.

These massive cash expenditures reflect the competitive nature of the cloud business. The operating costs of Google Search are relatively low, generating huge advertising revenue with minimal expenditure, while these new AI businesses are actually consuming a lot of cash. Part of the reason is that competition in this field is very fierce: companies are competing to drive up the prices of memory and semiconductors. Therefore, Google is operating in an environment that is more competitive than its traditional business and hopes to stand out

What Berkshire Might Be Thinking

In summary, the current situation looks negative, or at least risky, for Google. Nevertheless, one of the world's most respected financial companies is buying into this stock. We should ask ourselves what Berkshire sees in Google, considering the company's plans for hundreds of billions of dollars in AI capital expenditures each year.

Today, Google has several favorable factors. These include:

1. Its self-designed AI chips, known as Tensor Processing Units (TPUs). This slightly reduces the company's dependence on Nvidia compared to its competitors.

2. The company's traditional business remains strong, with Google Search maintaining a stable 90% market share as disclosed in its latest financial report.

3. The company has 13 different products, each with over 1 billion users.

4. Google Play occupies half of the duopoly in the Western smartphone operating system market.

These facts indicate that Google has a significant competitive advantage across multiple verticals. Of course, they all bring cross-selling opportunities, as can be seen from the various subscription services offered by the company, such as Google One.

When Berkshire's fund managers discuss whether to invest in Google stock, they may consider some of the facts mentioned above.

Additionally, a company's success in operating its own products and services provides assurance for supporting its cloud computing customers. This support includes developer tools, more consistent uptime, and so on. Over time, Google's excellent reputation among developers should attract more and more customers to use its cloud computing products.

Valuation

After considering the above factors, we can make a rough valuation of Google stock. Google has enough positive factors that we can safely assume its earnings will at least remain at current levels and may grow to some extent in the future. According to Seeking Alpha Quant data, Google's earnings per share (EPS) over the past 12 months (TTM) is $13.25. Discounted at a 4.5% yield on 10-year Treasury bonds, Google's stock value is derived to be $294. This is significantly lower than today's price. However, recalling the company advantages listed earlier, Google is a very strong company relative to its competitors. Therefore, it is likely to grow to some extent with the growth of the U.S. economy. If you only set a 3% perpetual growth assumption, which is below the long-term GDP growth rate, the target price would rise to $833. Historically, Google's earnings and free cash flow (FCF) growth have far exceeded 3%. Therefore, there is ample reason to believe that Google's stock price has a long way to go. But A.J. Button does not actually intend to set the target price at $833, as "perpetual growth" is a metric that is difficult to predict. However, even assuming steady growth over the next 10 years, it is easy to arrive at a target price of $500. Thus, A.J. Button believes that Google remains a worthy buy