Head In The Clouds, Google (Issue #31)
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Pillars:
Competitive Advantage - Owns the 3 biggest Search Engines in the world
Fortress Balance Sheet - $1.3T Market Cap with $99.8B in Liabilities
Growth - Cloud Business
Long-Term Focus - High spending on long-term assets like Google Cloud
Capital Allocation and Operation - Uses cash from Advertising to invest in Other Bets and Google Cloud
Undervalued In Context - At an extremely discounted multiple for all tech especially a high-quality company
Owner of the three largest search engines in the world, Google Search, Maps, and YouTube, Alphabet is a becoming force for growth. Already, for standard search engines, Bing is ranked number two with a 3% market share compared to Google’s ~90%. This doesn’t even include Alphabet’s many other ventures and pursuits including the G Suite, Android, Google Cloud, Other Bets, and much more.
Google Headquarters is not really like any other company. Even the other big silicon valley tech companies can’t compare. I’ve personally visited the campus twice and the energy to create and innovate is palpable. The community created there makes it a place no engineer would want to leave. This is a product of the fun amenities like everything from cooking classes to onsite massage therapists to having world class speakers coming to the campus. These benefits draw in the highest quality employees. The people are extremely curious as well not just about tech, but across the board. There is a reason Google Talks–where the company or clubs within it bring in world-class speakers everyone from Aswath Damodaran to Ryan Reynolds–are so highly regarded and they often have nothing to do with the work the engineers are doing. If these employees are that talented at their hobbies imagine how amazing they must be at their main roles. Actually, we can tell! Just look at their numbers.
The majority of Google’s revenue comes from advertising with a combined ~$56bn of their ~$70bn revenue in Q2 2022 coming from ads and ~$7bn of that from YouTube alone. Google is quite efficient with its income. The company converts >20% of revenue into Free Cash Flow (FCF).
Source: Alphabet 10Q Q2 2022
Alphabet divies up its revenue into 3 sections. (This was a new development that came with the CFO Ruth Porat who joined in 2015.) Each of the sections is built for a different market. Cloud for enterprises, Google Drive (Docs, Sheets, Slides, etc.) for small-medium businesses, and search for the masses of individuals.
The first up is Google Services which includes all advertising as well as subscriptions and in-app purchases of content across platforms. Advertising accounts for ~90% of revenue from Google Services. An important part of Google Services is YouTube. YouTube is one of the best streaming services around with billions of sticky users instead of millions. Also aside from YouTubeTV they don’t pay for content. Finally, they have a better understanding of advertising in video content than almost any other company. Even though the company does still offer streaming options, more streaming services like Netflix are now adapting to be like YouTube than vice versa.
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Also, I think it’s an urban legend that anyone actually has YouTube Premium. Apparently, it is not as Google recently announced they have a combined 50 million subscribers to YouTube Music and Premium. This is significant and made even more so as it is a 20 million subscriber increase from last year. At the same time, this is not a high percentage of YouTube’s over 2.5bn active users.
Next is Google Cloud which encapsulates Google Workspace tools like Google Drive for enterprise and email for the enterprise under their Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) branches. Although Google is a dominant force in most markets they compete in they are only the third biggest in cloud behind Amazon’s AWS and Microsoft’s Azure.
Google Cloud - Revenue Q2 2022: $6.3bn
Amazon AWS - Revenue Q2 2022: $19.7bn
Microsoft Azure - Revenue Q2 2022: $17.4bn
Google Cloud is growing at ~44% annually, but this has not been cheap (~$24bn CapEx mainly spent on Cloud development). Over the past 3 years, the average annual revenue growth has been ~34% for AWS and ~25% for Azure. These are all high growth rates for parts of trillion-dollar businesses. These businesses will be important parts of these companies’ moats in the future, especially for Google.
Finally, Other Bets is comprised of start-ups in every possible growing tech or healthcare area. Everything from Drone delivery to healthcare to autonomous driving. An example of a successful Other Bet is YouTube which has now grown to the second-largest search engine in the world. Other Bets works as an in-house Venture Capital Firm for Google focused on all things Silicon Valley.
Having an extremely high market share in search also gives Google the long-term benefits of having data like no other company (besides Meta). As data of all forms not just personal becomes more valuable and important many of Google’s natural advantages will begin to appear. Google can be increasingly thought of as an AI company. This means they are evolving from a tech company. The best way to think about this is that a company with a website or app isn’t a tech company similarly a company with AI is not an AI company. Google could be thought of as an AI company because they are data focused and driven. They have begun to have adopted a more decentralized creation within the company. This means that product managers have more importance and adjusted roles. They do not need to show how an AI program should look, but they need to show through algorithms and things how it will operate.
Initially purchased for $1.65bn YouTube now does ~$25bn in revenue every year. This is a great example of a successful Other Bet and one of the best acquisitions ever.
Their cash efficiency is also enticing as it allows the company to use the money made from advertising (the main engine) to strengthen Google Cloud and make additional Other Bets. On top of this, Google Ads still has room to grow with some reports saying it could hit over $780bn in revenue in the next couple of years from its current ~$200bn annually.
Google is strategic about being efficient with capital while strategically spending money too. For example, they pay Apple (AAPL) $10-$15bn annually for Safari to use Google Search. This Traffic Acquisition Cost (TAC) is well worth being a core pillar of Apple’s system that can seem almost impossible to break into for some other tech companies. The company has also made some actions to compete with Apple and Microsoft with Android and Chromebook. They have not taken away from these companies' markets as much as they have created new markets and served others who have lower price ranges for products.
Competitors
Google and Alphabet don’t really have one direct competitor, however, it competes with many companies large and small at a number of different locations. For example, Alphabet competes with Facebook/Meta, TikTok, and streaming services on a content front with YouTube. Important to note that Google has a low presence in China–the best internet/streaming market in the world–but growth in this market would bring the company to a new level.
G Suite has a clear competitor in Microsoft's Office365. Google does offer more services for free, however, Excel and Word are the across industry-standard, not Google Sheets or Docs. They are a strong number two that doesn’t seem to be going anywhere. G Suite is also aimed at small-medium businesses whereas Office365 is more focused on larger enterprises.
A big place for competition is between Android and Apple. Apple has a high market share in the US, but Android has a strong global presence. Originally it was just a fight between operating systems, but now with the Pixel and Pixelbook the competition is more direct and on multiple axes. Most people in the US do not understand how important Android is on the world stage. Android is the most popular mobile operating system globally.
Capital Expenditures (CapEx) for 2021 were ~$24bn. The company said that the majority of this was allocated to data centers and other resources for cloud. This widens their moat because their are only two other companies with the resources to compete on this level, Microsoft and Amazon. For Google Cloud, the company stores a lot of personal and professional information (i.e. photos, videos, and drive materials). However, they do not have the same quantity of cloud offerings compared to Amazon’s AWS or Microsoft’s Azure because Amazon was there first and Microsoft inherently works to help enterprises with technology. This makes Google Cloud number three for cloud which is working hard to catch up. However, Cloud is a strong third leg of the stool or growth area for Google. Google Search only has room to grow in international markets like China and Europe, but Cloud is still young enough that more investment now can still put it up there with Azure and AWS. This would also be a worthwhile investment as cloud is a big enough market to have a meaningful impact on the company as a whole. Google Cloud CEO Thomas Kurian has been positioning Cloud to industrialize cybersecurity and use that as a competitive advantage over AWS and Azure. Google Cloud is still far back, but they are growing by thousands of employees and ~44% in revenue per year and its growth is outpacing Alphabet as a whole at a 23% revenue growth rate. At this growth rate (discounted to 35% annually for years 4 and 5 of the projection) Google Cloud will be well over $100bn in revenue by 2027.
Risks
Working in information gathering and advertising as well as internet content distribution comes with some risks. For example, regulation. There is a lot of legislation around information gathering and many loopholes and technicalities that large tech companies like Google exercise. This makes them potentially susceptible to legal prosecution or limitation that could cost them meaningful returns.
Privacy of user information practices is the largest current risk to Google’s success, however, this is also one of its largest advantages. The access to information will be increasingly subject to new legislation, but it also allows for more accuracy in their services and ads.
Valuation
Alphabet has seen an average ~29% annual growth in revenue over the past 5 years. On top of this Gross Margins have been at an average ~56% for the past 5 years. The margins have been steady during this time with a slight increase of less than a percent over time. The company has also been growing FCF at a higher rate than revenue. This is an amazing accomplishment and something that makes Alphabet a strong investment opportunity.
Google owns the three largest search engines in the world not to mention owning one of the world’s largest Cloud services and much more. They are the quintessential tech company. One would expect this to warrant an astronomical multiple, but Alphabet trades at a cheap 13.91x Price/Cash Flow and 18.38x Price/Earnings. This is one of the most important companies in the world and it trades at a valuation comparable to Visa (V) which is a trailing competitor in its respective market. These aren’t just cheap for a tech company, but also for just about any other industry. To be fair, everything is trading at a reasonable price right now, but even if you say the stock is down 50% from where it should be trading that is a potential to double your money. Also, this would mean a 27.82x P/CF and 36.76x P/E which are still half of typical tech sector multiples.
This low multiple says that the market thinks this a company with slow growth and minimum returns. However, this is not the case. Google already has strong returns and as Cloud becomes a bigger part of their business the growth should only accelerate. In addition, Google already has remarkable base companies in Search, Maps, and more. As results start to be seen in the next few years from the billions invested in Cloud the discrepancy between multiple/price and performance should go away or at least be reduced.
Investment Thesis
The three cores of the management team are CEO Sundar Pichai who has been a part of Google since I was born (2004). He became CEO of Google in 2015 and absorbed the role of Alphabet CEO in 2019. The next core is CFO Ruth Porat who joined as CFO of both Google and Alphabet in 2015. Previously she worked at Morgan Stanley for 27 years and was CFO there from 2010. It is clear that Google/Alphabet has a very strong financial strategy because of Porat. For example, they do not pay dividends unlike Apple and Microsoft, but they have been rapidly repurchasing stock. Currently, the company is on track to buy back ~$70bn of stock in 2022. That is more in buybacks than the market cap of the majority of companies in the world. A recent stock split also incentivized a lot of new investment. The final core is Thomas Kurian CEO of Google Cloud since 2018 who has been a driving force in its success so far and setting the company up for what seems like a strong future.
Alphabet is one of the three most dominant companies in the online advertising space along with Meta and The Trade Desk (LINK). They are efficient with capital and convert a high amount of revenue to FCF. They are also in possession of some extremely valuable intangible assets. For example, owning the 2 largest search engines in the world and having ~90% market share of all internet searches. This makes them essentially the number one way people interact with the internet. If that’s not a competitive advantage I don’t know what is. Looking forward I will be watching to see how Google Cloud grows and the role it plays in Alphabet’s future.
Until Sunday,
Soren
Disclaimer: Soren Peterson and Pillars And Profits Newsletter are not responsible for any investment results. This is not financial advice. Always do your own research.