Google parent Alphabet Inc is scheduled to report its earnings results for the second quarter on Tuesday after the market close. With all the rage about Artificial Intelligence (AI), Alphabet has a lot to live up to as it has to prove to investors that it can keep up with Microsoft, which at the moment, is leading the AI race. Alphabet may yet have a few tricks up its sleeve but how well its ad business is faring will be just as important for the stock, which has been lagging its pears this year.

It's all about AI

There can be no denying the power that AI has on a company’s stock price, as only recently, Alphabet shares rallied after Google announced some new features for its Bard chatbot. However, as exciting as that may seem, Bard remains a standalone product for the time being and there is no timeline on how quickly Google intends to integrate its AI tool into all its products and services such as its popular search engine. And even though Google has already started to roll out generative AI capabilities for its Workspace business solutions, its biggest rival is ahead of the game.

Microsoft has not only adopted its recently acquired AI platform ChatGPT into its Bing search engine, but it will soon launch an AI assistant for its Microsoft 365 product suite for a monthly fee. The fact that Alphabet seems a few steps behind Microsoft in monetizing AI puts it at a significant disadvantage. But then again, Microsoft is the exception and Alphabet is probably better placed than the other big tech players in playing catchup.

Ad business in focus

But whilst investors will undoubtedly want to hear more about the company’s AI strategy, Google’s advertising and cloud businesses will also be in the spotlight. Google Ads has long been Alphabet’s main revenue stream, but pressure is growing from both sides of the Atlantic to split it up. US regulators want to see the technology behind its advertising platform to be broken up from the search business, while EU regulators are calling on Google to divest its ad servers.

But that’s not the only headache Google has with the European Union as it is increasingly being forced to pay publishers in the bloc for their content that comes up in search results. Then there’s the question about whether or not the use of AI in Google Search would change how advertised content appears, specifically, if more space on the page would need to be reserved for AI-generated responses at the expense of sponsored results.

The immediate concern, however, is how higher interest rates and the economic slowdown globally is weighing on online advertising revenue. The consensus analyst forecast according to Refinitiv I/B/E/S Estimates is for ad revenue to have increased by 2.3% year-on-year in the second quarter to $57.60 billion.

Growing reliance on cloud revenue

The performance of Google Cloud Platform will also be extremely important for investors as this is increasingly seen as the future driver of revenue growth. The cloud unit made a profit for the first time ever in the first quarter, but even if it slips into losses again, as long as revenue growth holds up, this should please traders. Any update about how AI is being used in this segment could also be significant.

There are other bright spots too. The company’s subscription services such as YouTube Premium and YouTube Music continue to grow and its updated Pixel phone and tablet range likely boosted hardware sales. In addition, there may be some exciting developments in the ‘Other Bets’ division, for example, the application of AI in healthcare.

Looking at total revenue for Alphabet, it is expected to come in at $72.94 billion, which would represent an annual rise of 4.7%. Earnings per share (EPS) are forecast at $1.34, down from $1.17 in the prior quarter but up more than 10% from $1.21 reported a year ago.

Alphabet stock still ‘cheap’

From a valuation perspective, Alphabet is the ‘cheapest’ at the moment among the Big Tech with a trailing price/earnings (PE) ratio of about 24. Its forward PE is favourable too. The main reasons for this relative underperformance in the stock price are the ongoing risk of the breakup of Google Search and other regulatory hurdles, as well as the fact that Alphabet has yet to turn its cloud division into a cash cow the same way as Microsoft and Amazon have.

Moreover, Microsoft’s lead in the AI space has exposed risks for Google Search, which is in danger of losing market share to Bing. For a company like Alphabet, simply being part of the AI race may not be enough and its top executives have some distance to climb to convince shareholders that they have a solid plan to stay at the top of their game.