Alphabet's $50B Cloud Business Gives It AI Edge

Alphabet (GOOG +1.53%) (GOOGL +1.77%) has come under pressure lately as management pushes forward with its massive AI spending plans. Not only does it expect to spend around $200 billion in capital expenditures this year and significantly more next year, it also has $811 billion in purchase commitments and contractual obligations on the books, most of which it will pay by 2030. Some investors are worried that Alphabet may be spending too much on AI, especially as its free cash flow dips into negative territory, and it taps debt and equity markets for new capital.

Google Cloud CEO Thomas Kurian revealed a few details about the cloud computing business that should give investors confidence in its future, including the fact that it's sitting on a rapidly growing $50 billion business that gives it a huge advantage over the competition.

Alphabet's custom AI chips are a huge hit

Kurian revealed that Alphabet's Tensor Processing Unit (TPU) chips business, which it uses versions of for both AI training and inference, is more than twice the size of its next-closest competitor. That would be Amazon (AMZN +1.94%), which disclosed that its custom chips business -- which includes its Trainium AI accelerators and Graviton central processing units (CPUs) -- reached a $25 billion run rate in July.

That is to say, Alphabet is on track to generate over $50 billion per year from TPUs. For reference, the company reported $24.8 billion in revenue for the entire Google Cloud segment last quarter, so the TPU business is around half of that.

Key Data Points

With such a large percentage of Google Cloud revenue coming from TPUs, Alphabet is seeing a very short payback period for its AI servers relative to its competition. Kurian said the average payback period for its servers was less than two years, and TPU servers break even in half that time.

For comparison, Amazon CEO Andy Jassy said the payback period on AI servers in Amazon Web Services is just under three years. That's still a good breakeven period given that the expected lifespan of a server is about six years, but cutting the breakeven period from three years to two years means Alphabet can generate twice the cash returns on its servers over a six-year period.

A massive advantage in the AI race

Perhaps the biggest challenge for hyperscalers right now is access to capital. All of them are selling bonds for capital to invest in building new data centers. Alphabet even went so far as to issue new stock to raise $85 billion earlier this year.

The capital efficiency of TPUs is an excellent advantage over the competition. With so much demand for its chips, Alphabet can invest aggressively in building out new data centers and outfitting them with TPU servers. TPUs likely cost much less than third-party GPUs, enabling Alphabet to deliver more compute with the same capex budget as competitors that are more reliant on GPUs.

It's worth noting that Amazon plans to deploy more Trainium servers this year than GPU servers. Microsoft (MSFT +0.65%), likewise, is planning a big ramp-up of its custom silicon. But their custom silicon businesses are smaller than Alphabet's on an absolute basis, and especially so relative to the size of their overall cloud computing operations. Note that both Amazon's and Microsoft's cloud revenues are higher than Alphabet's.

Key Data Points

Meanwhile, Alphabet has locked in some of its biggest customers with long-term commitments, many of which are five years, according to Kurian. That gives it very good visibility into its potential cash returns on building more data centers and standing up more servers. With one-year payback periods on its TPU servers and an average of two years overall, it will soon return to its massive cash-generative self in just a few years once it gets past the initial data center build-out.

Investors can get a bargain price on Alphabet stock right now, though. It trades for just 16 times forward earnings expectations. Amazon and Microsoft trade for approximately 20 and 25 times earnings expectations, respectively. With the potential to generate enormous cash returns on massive spending, Alphabet looks like a great investment opportunity right now.