The recent announcement by Alphabet (GOOGL.US) to raise up to $80 billion in financing, including a $10 billion investment from Berkshire Hathaway (BRK.US) at approximately $350 per share, has sparked significant discussion. While the news initially led to a sell-off as some investors perceived the deal as favoring Berkshire at the expense of existing shareholders, a closer look at the capital's intended use suggests the move may be strategically sound.

Examining the Timing and Strategy

The decision to issue new equity is not surprising. The company is in the midst of a massive build-out for artificial intelligence, and its stock price is not far from all-time highs. This presents a classic scenario where a company with a major investment opportunity and an elevated stock price can raise capital efficiently. Therefore, the company and its shareholders appear to be in an advantageous position. This leads to the question: how long can this favorable situation last?

Assessing Valuation and Performance

While Alphabet is undoubtedly a great company expected to remain excellent for years, its stock has reached levels few anticipated early last year. Berkshire's investment indicates belief in the company's value, but it is entering at a perceived discount. Based purely on price momentum, the rally may be unlikely to continue, and the significant gains over the past six months, one year, and five years might intuitively suggest a pullback is due. However, the fundamental story presents a different picture.

The company is highly profitable with strong margins and returns on capital. For a company of its size, its growth is remarkably fast, with earnings growing 22% over the past twelve months. Despite this stellar performance, its valuation remains relatively low compared to its sector, with a price-to-earnings ratio of 29, below that of the Nasdaq 100 index. Thus, based on both historical performance and current value, the stock seems like a compelling choice.

Navigating a Changing Competitive Landscape

The core challenge lies in determining whether Alphabet's strong performance can persist into the future. The company's strength is built on a powerful, interconnected ecosystem of products and services with wide moats, several of which boast billions of users. This ecosystem has been the primary driver behind its stock price surge above $350. However, the technology world is evolving, with intensifying competition in AI—the very segment the company is now heavily investing in. Consequently, given its past gains and the industry's transformation, the investment thesis requires re-examination.

Understanding the Equity Raise and Its Implications

The first major change since the last analysis is the company's decision to issue new equity for the first time in years, aiming to raise a substantial $80 billion. It is worth exploring what Alphabet gains in exchange for this shareholder dilution. According to the company's announcement, the funds are earmarked for AI computing and infrastructure, meaning data centers, servers, and other semiconductors essential for running its numerous AI applications. These include AI-infused products like Search, YouTube, and Google Drive, as well as selling computing power to third-party developers via Google Cloud.

It is in this second category where the situation becomes more complex. Google Cloud, a relatively newer part of the business that first turned profitable in 2023, operates in a fiercely competitive arena against major rivals like Amazon (AMZN.US) AWS and Microsoft (MSFT.US) Azure. This is not an exclusive business like Google Search arguably remains. The competition involves selling AI server time to web developers, with a significant recent portion of business involving selling access to NVIDIA (NVDA.US) chips as a service.

The cloud business also has a software component, such as hosted developer tools, where there is some room for differentiation—for instance, by offering proprietary applications exclusively on one's own cloud. However, the space is intensely competitive, with three of the "Magnificent Seven" vying for the same business, alongside smaller players like Oracle (ORCL.US) and several Chinese companies.

So far, Google Cloud appears profitable despite the competition, with operating income of $6.5 billion last quarter, up 200% year-over-year. However, the company also saw a sequential decline in free cash flow in the same period, primarily due to massive cash outflows for AI builds. The company estimates full-year 2024 capital expenditures between $180 billion and $190 billion. While earnings remain robust, cash flow has been volatile, showing year-over-year or sequential declines in recent quarters. These substantial cash outlays reflect the competitive nature of the cloud business, which consumes significant cash compared to the relatively low-cost, high-ad-revenue model of Google Search.

Berkshire's Perspective and Key Strengths

Given the above, the current situation for Alphabet appears challenging or at least risky. Yet, one of the world's most respected financial firms is buying the stock. It is worth considering what Berkshire sees, given the planned multi-hundred-billion-dollar annual AI capital expenditure. Several factors work in the company's favor:

1. Its self-designed AI chips, called Tensor Processing Units (TPUs), which reduce reliance on NVIDIA compared to some competitors.

2. Its core traditional business remains strong, with Google Search maintaining a stable 90% market share as per the latest earnings report.

3. The company boasts 13 different products, each with over one billion users.

4. Google Play holds half of the Western smartphone operating system duopoly.

These facts indicate considerable competitive advantages across multiple verticals, offering cross-selling opportunities evident in various subscription services like Google One. Berkshire's managers likely considered some of these factors. Furthermore, the company's operational success with its own products provides a foundation for supporting cloud computing customers with developer tools and reliability, which over time could attract more clients to its cloud offerings based on its reputation.

Final Valuation Considerations

After considering these factors, a rough valuation can be attempted. With numerous positive attributes, it is safe to assume earnings will at least be maintained and likely grow to some degree. Based on trailing twelve-month earnings per share of $13.25 and discounting at the 10-year Treasury yield of 4.5%, a base stock value of $294 is derived, significantly below the current price. However, given the company's strengths, it is likely to grow alongside the U.S. economy. Assuming a modest perpetual growth rate of 3%—below long-term GDP growth—the target price rises to $833.

Historically, Alphabet's earnings and free cash flow growth have far exceeded 3%, suggesting the stock has considerable room to run. While setting a target of $833 based on perpetual growth is speculative, even assuming steady growth over the next decade easily supports a target around $500. Therefore, the conclusion remains that Alphabet stock is still a buy.