Why Alphabet’s Own AI Chips May Be Its Quietest Advantage

Nvidia is the company best known for artificial intelligence (AI) chips, and that's because its graphics processing units (GPUs) have powered the training of the world's top models. And as a result, earnings have soared. But a quieter chip story is unfolding at Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL), and investors may just begin to see it in the company's financial results.

Alphabet has spent years designing its own AI chips, known as tensor processing units, or TPUs. For most of that time, these chips mainly served Google's own products and its cloud customers. This year, though, Alphabet started selling TPU systems directly to customers who want to run them in their own data centers.

So, why might the TPU be Alphabet's quietest advantage? Let's find out.

Image source: Getty Images.

From AI worry to AI winner

First, a quick look at how Alphabet got here. Not long ago, some investors worried the company would be a casualty of the AI era, with the idea that chatbots would pull users away from Google Search -- if that happened, it would clearly hurt advertising, which is Alphabet's bread and butter. Those worries haven't played out. In the second quarter, Google Search revenue grew 17%, and Google advertising represented 68% of total revenue.

Meanwhile, Google Cloud, the company's cloud computing arm, has been picking up serious momentum, with revenue advancing 63% in the first quarter and then 82% in the second, to reach more than $24 billion. And the cloud backlog, which represents contracted commitments not yet recognized as revenue, hit $514 billion, with just over half expected to convert to revenue within 24 months.

Where the TPU fits in

Here's where the chip comes in. Unlike a general-purpose chip, a TPU is designed with AI workloads in mind, and Alphabet has refined the technology across multiple generations. That gives the company two potential benefits. First, it can run its own AI services and those of its cloud customers on hardware it controls, rather than relying solely on Nvidia's supply and pricing. Second, it can now sell that hardware as a product.

Earlier this year, Alphabet announced that it would start selling "multiple gigawatts of TPU hardware" to a select group of customers for use in their data centers, and in the second quarter, Alphabet recognized revenue from TPU system sales for the first time. Management said it's still a small piece for now, with most of the revenue expected in 2027. A Citizens analyst in a May note said the company may deliver around $3 billion of revenue from TPU-related infrastructure this year and $25 billion next year, according to Fortune.

This doesn't mean Alphabet is on track to replace Nvidia or other major chip designers. Nvidia and direct peers built a dominant business by selling chips broadly across the market. Alphabet, through its TPU business, has a chance to build a second profit stream on top of an already thriving cloud and advertising business -- it doesn't have to win over the entire chip market.

What to watch

Of course, there are risks. TPU sales are early, and as mentioned, most of the revenue won't start flowing in until next year. To support some of these agreements, Alphabet has agreed to provide credit backstops for third-party data centers and power infrastructure -- this adds a layer of financial risk. Developers also remain highly committed to Nvidia's ecosystem, so Alphabet's chips will have to keep proving themselves.

Still, this new step in the AI chip market is positive for Alphabet. The tech giant has a fast-growing cloud unit, a resilient and leading search business, and now a chip business that offers more control over costs and a new source of revenue. All of this reinforces the buy case for Alphabet amid this ongoing AI story.

Adria Cimino has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet and Nvidia. The Motley Fool has a disclosure policy.