Generative Artificial Intelligence (AI) Is Exploding: 2 Stocks to Snag Now

It’s been almost a year since ChatGPT was commercially released. And after its meteoric rise, companies of all sizes quickly realized just how crucial artificial intelligence (AI) is going to be for digital transformation.

Perhaps unsurprisingly, big tech has been leading the charge when it comes to showcasing AI applications. Both Alphabet (GOOGL 1.69%) (GOOG 1.61%) and Amazon (AMZN 1.58%) are investing aggressively in AI to bolster business segments, such as cloud computing, advertising, and e-commerce.

Over the last several months, new AI-powered services have helped propel each of these technology behemoths forward. While AI is still in its early innings, both of these companies are already beginning to separate from the pack. Investors may want to take a closer look at Alphabet and Amazon now before the prospects of AI get priced into the respective stocks.

1. Alphabet

Alphabet’s largest revenue stream is derived from advertisements on Google and video-sharing website YouTube. While Alphabet dominates online consumer search, the company has faced challenges in its advertising anchor for the last year or so. These challenges primarily hail from alternative social media applications, such as Instagram (owned by Meta Platforms) and TikTok, the short-form video application widely used by Gen Zers and millennials.

The table below illustrates changes in annual growth rates in Alphabet’s advertising segment over the last couple of years.

Item Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023
Google Search & other 24% 14% 4% (2%) 2% 5%
YouTube ads 14% 5% (2%) (8%) (3%) 4%
Google Network 20% 9% (2%) (9%) (8%) (5%)
Total Google advertising 22% 12% 3% (4%) 0% 3%

Source: SEC Filings.

It is easy to see that growth in overall advertising revenue from Google has decelerated. On the bright side, Alphabet’s second quarter posted a return to growth in advertising, and the company appeared to make noticeable strides in Search and YouTube in particular.

Management spoke at length during the company’s Q2 earnings call about its approach to fend off the competition in the advertising space. For instance, Alphabet explained that one of the pain points for advertisers is setting up marketing campaigns quickly. As a result, Google released a large language model (LLM) that marketers can use to help create their campaigns.

The value-add of this tool is that the LLM’s responses are based on Google’s extensive library of advertising data. Therefore, marketers can get a better sense of how to create targeted ads more efficiently.

Another new feature Alphabet launched was a virtual try-on tool powered by generative AI. In essence, Alphabet is helping bring the fitting room experience right to the consumer. In theory, this can help speed up sales processes and increase profitability for retailers.

Management specifically highlighted that the value these immersive and engaging experiences create could greatly benefit small and mid-sized enterprises. This is really interesting because it demonstrates just how broad Alphabet’s reach is when it comes to customers. Alphabet is not only looking to partner with other large businesses but also creating an ecosystem of products and services that benefit companies of all sizes.

Although advertising is Alphabet’s main moneymaker, the company is also gaining momentum in the cloud computing space. The table below shows revenue and operating income for Alphabet’s cloud suite, dubbed Google Cloud Platform (GCP).

Item Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023
Google Cloud revenue $5,821 $6,276 $6,868 $7,315 $7,454 $8,031
Google Cloud operating income / (loss) ($931) ($858) ($699) ($480) $191 $395

Source: SEC Filings. Figures in billions of dollars.

This is about as good of a trend as you could ask for. GCP has been growing revenue consistently on a sequential basis while trimming losses to the point where the segment is a consistently profitable operation. One of the catalysts driving GCP is its “AI-optimized infrastructure.”

This means that Alphabet is engraining generative AI throughout the fabric of its entire cloud suite. As a result, GCP customers have access to loads of sophisticated data models that can be used across myriad use cases. For example, Alphabet’s generative AI tools help customers like Priceline (traded as Booking Holdings) with trip planning, and they assist financial institutions like HSBC with identifying and thwarting money-laundering schemes.

Generative AI is also playing a major role in Google Workspace — home to productivity tools, including Gmail and Google Drive. Management highlighted that Instacart is using a new product called Duet AI, which layers on top of Workspace and is geared toward helping services companies better engage with customers.

GOOGL Price to Free Cash Flow data by YCharts. PE Ratio = price-to-earnings ratio.

The graphs above illustrate the price to earnings (P/E) and price to free cash flow for Alphabet stock. Investors can see that the stock is trading well below its highs from a few years ago. Like many technology companies, Alphabet experienced higher-than-usual growth during the peak of the COVID-19 pandemic. However, over the last year or so, the stock has taken a major breather as growth decelerates in advertising in particular.

Furthermore, given the aggressive moves by Microsoft in particular — a major investor in OpenAI — some on Wall Street may be doubting Alphabet’s future growth prospects. More specifically, as ChatGPT integrates with Microsoft’s search functionality (called Bing), some may be wondering whether Google will begin losing market share. Should this be the case, advertising revenue will likely be hit pretty hard.

With all this said, perhaps the most lucrative part of Alphabet’s generative AI suite is that it is becoming naturally stitched into the company’s entire ecosystem, thereby presenting enormous cross-selling potential among customers. In other words, Alphabet’s large, growing customer base will be interacting with generative AI natively built into its products. Therefore, businesses should continue to discover new use cases and increasingly adopt additional AI-powered applications.

In turn, these customers will rely on Alphabet as a full-spectrum generative AI platform. It’s this dynamic that has notable investors, such as Bill Ackman, taking a bullish long-term stance on Alphabet stock.

Despite competition from big tech cohorts and upstarts alike, I cannot help but take the view that the revenue and cash-flow upside from AI for Alphabet is massive. Moreover, while the stock has run up over 50% so far this year, I think the best is yet to come. To me, Alphabet’s returns so far this year have been driven more by the narrative and hype around AI and less by concrete results.

The company’s second-quarter results were likely just a preview of what’s to come. Investors will get an even more thorough download this week when Alphabet reports Q3 earnings on Oct. 24. I’d listen closely to what management has to say regarding AI and monitor the price movement in the stock accordingly.

A person using generative AI to assist writing software code.

Image source: Getty Images.

2. Amazon

Another company benefiting from the tailwinds of generative AI is Amazon. While Amazon is most commonly affiliated with its flagship e-commerce platform, the company has actually built a leading cloud computing enterprise. The table below illustrates revenue and operating income trends for Amazon’s cloud segment, Amazon Web Services (AWS).

Item Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023
AWS revenue $18,441 $19,739 $20,538 $21,378 $21,354 $22,140
AWS operating income / (loss) $6,518 $5,715 $5,403 $5,205 $5,123 $5,365
AWS annual revenue growth % 37% 33% 28% 20% 16% 12%
AWS annual operating income growth % 53% 28% 1% (10%) (26%) (8%)

Source: company filings. AWS = Amazon Web Services. Dollar amounts in billions.

When it comes to the cloud, Amazon primarily competes with Microsoft Azure and GCP. Investors can see that over the last several quarters, revenue growth in AWS has slowed, and profitability has shrunk. Given that this is a core pillar in Amazon’s business, investors would be right to express concern over the trend lines above. However, similar to its big tech cohorts, Amazon has been heads-down building its own AI strategy, specifically aimed at bolstering AWS.

Amazon recently announced an investment in AI unicorn Anthropic. As part of this investment, the start-up will be using AWS as its primary cloud provider. This agreement has the potential to be a bellwether for lead generation for AWS because it opens the door to marketing new products to Anthropic’s customers.

Moreover, Anthropic will train its future generative AI models on Amazon’s homegrown chips called Trainium and Inferentia. This could be a game-changer for Amazon as it allows the company to make a splash in the semiconductor industry, which is primarily dominated by Nvidia and AMD.

Similar to Alphabet, Amazon stock has enjoyed its share of upward momentum this year. But as the chart below shows, the company is trading 50% off its three-year historical highs from a price-to-sales (P/S) standpoint.

AMZN PS Ratio Chart

AMZN PS Ratio data by YCharts. PS Ratio = price-to-sales ratio.

Given that AI is so nascent, I think the investment community is waiting, perhaps even perplexed about which companies will emerge winners. For this reason, even big tech stocks have witnessed some stalled activity. I think the investment in Anthropic was a savvy, albeit much-needed, move by Amazon.

While the tailwinds of the alliance will take considerable time to recognize, it’s clear that management is doing what it needs to for long-term growth. Given the long-term secular tailwinds of cloud computing and the rising demand for generative AI, AWS looks well positioned to reach its next growth phase.

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