It was a spectacular quarter for the tech titans. When I was at Microsoft, I wrote product and business analysis of major competitors; it’s been a while so I thought I’d dig in on them again. Last week I picked apart Amazon earnings. This week it’s Alphabet!
I already covered one aspect, their transparency about “other bets”, which I appreciate. Now let’s dig into the meat.
A few basics…
Since not everyone has been following Google for years, let me lay a foundation.
Google’s business is ads. They have an ad system that takes data and context, makes inferences about users, and then sell space on websites to advertisers.
Most of the ad sales take place on a set of Google websites, primarily search. Secondarily they “rent” space on lots of other websites via Adsense and other services.
Every other business at Google falls into a couple of other categories:
- Money-losing bets (Nest, Fiber)
- insignificant side businesses (blogger, Gmail)
- Strategic bets intended to support the ad businesses (Android, YouTube)
In spite of many efforts to diversify, Google continues to be mostly about search and entirely about ads. They’ve done a stunning job of making the search/ad business incredibly lucrative, but not much else from a business perspective.
Overall state of Alphabet
Let’s look at the actual numbers. I’ve reworked and simplified the tables from their 10-Q, shown below (data is for the September quarter of each year):
After their earnings came out, Google participated in the spectacular tech rally, popping 2% on the news. The table above tells the tale. On a YoY basis, revenue is up 19%. I continue to be impressed that Google can turn in this kind of growth given that it’s nearly all internet advertising. Shouldn’t that business be maturing? Apparently not.
Note the Gross margins declined somewhat as Google’s cost of goods have increased – so one sign of maturity is that they are working harder to get the growth they’re seeing. This comes from increased payments to partners and for traffic, and from decreasing costs-per-click that was made up for in volume of clicks.
But still, a great performance.
The next lines are optional, fixed costs. Here’s where Google Leadership’s maturity shows – they are increasing these lines much less than revenue or even GM. The result is that operating income – the closest thing to true profit – is growing much faster than revenues!
This is clearly a well managed, maturing company where both the top line and bottom line are growing. It also is the stage where unless some amazing new opportunity emerges, they will grow revenues with the market and get growth through cost management. This is roughly analogous to Microsoft as the PC market matured and slowed; when you dominate the market you pretty much ride its trend. See also Apple and iPhone.
It’s also predictable that GM and Operating income percentages will decline over time. GM will drop as additional dollars of revenue get tougher to pursue. Operating income percentages will drop as they get cut to the minimum and revenue growth slows.
Threats to Google’s Gross Margin
Google can choose to control most operating costs, but some aspects of the financials of their service can be beyond their control. Several have been eroding.
First, it appears they are in part growing revenues by cutting prices. This is seen in a long-term downward trend in Cost Per Click. Google doesn’t share the absolute number but does publish the changes. The volume increase more than offsets this, but it does mean they are working harder to get each additional dollar.
Second, Google’s Traffic Acquisition Costs (TAC) are rising. This appears to be mostly about the shift to mobile devices, where the owner of the device (e.g. Apple, or possibly the OEM or mobile operator) takes a bite out of search revenues in exchange for being the default search engine.
What does this imply about Google moving forward?
Google will have to get smarter about new bets, acquisitions, and emerging trends. During youth hypergrowth you can spend anything on wild dreams, but as things mature big spending comes right out of the profit trends. This is largely confirmed by the table below:
|Average Quarterly R&D Spend Change||Sept Quarter Spend|
|Amazon (Tech and Content)||10%||$5,944|
The more mature companies with slowing growth are growing R&D spend more modestly (including Google). Note that Amazon both spends the most and is growing the most; given my belief that Amazon is Google’s biggest enemy, this should worry them mightily.
If I were competing with Google in an area that’s not strictly core to their business, I’d breathe a sigh of relief. I’m looking at you, Microsoft Office. You too, Facebook. Google will have limited cash to invest, and will probably pull back to (a) efforts that protect and sustain the core search business and (b) really good future bets that leverage Google’s existing strengths.
Things Google should worry about
Google faces a number of challenges. Their 10Q is really poor in terms of outlining these, but I can name a bunch:
- YouTube ads. They call out this as a relatively poor advertising platform. It may be breakeven, or may not, but it certainly needs to improve.
- Facebook. FB is stealing their traffic, competing effectively for advertising dollars, and is spending aggressively to improve. They are effectively their only competition for pure internet advertising dollars. But Google is hugely dependent on this business.
- Amazon. Amazon is moving more customers away from searching for products on Google towards searching for them on Amazon.com directly. This cuts Google out of the equation and threatens some of the most lucrative audience and queries. Also, right now Amazon is investing more and executing better in most spaces than Google.
- Cloud. Google is late, late, late. And it’s unclear what space they can carve out between Azure (enterprise) and AWS (everything else). This is a huge lost opportunity to diversify.
- China. Google opted out of participating in this huge market, and local competition has become it’s own set of titans. Can Baidu come roaring out of China and steal some business from Google? It’s not likely, but it’s worth worrying about.
- Track record on new bets. Google’s M&A and new bet record is dubious. Google needs to get better at this.
- Mobile. Traffic is moving away from PC to mobile, hurting Google’s bottom line and moving traffic into apps away from the browser. This steals traffic and increases TAC costs.
- Middle Age Spread. I spend time with Googlers and watch them closely. Google feels like it’s entering middle age, analogous to post-DOJ Microsoft. Execution is lagging, and they lack energy. If I were leading Google this would worry me a lot.
This section can sound negative, so let me be clear: Google owns an amazing franchise, a monopoly on search, and is part of a duopoly on mobile OS’s. They are managing their core business exceedingly well and are printing money. But there are some cracks appearing.
Fascinating Random facts
- Google owns $40B in “property and equipment”. This is real estate and huge server farms. Kind of a stunning number.
- Google gets ad revenue from two places: their own sites and partner sites. Partner sites are a minority of the cash flow and are growing much slower than Google sites.
- Google is growing fastest in Asia, next fastest in the US, and slowly in Europe.
- Google has $100B in cash and securities, $32B in debt and payables. Pretty healthy and always growing.
- In addition to debt securities they’ve issued, Google has a $4B revolving line of credit with someone. They aren’t using it right now.
- Google’s board has authorized the repurchase of $7,019,340,976.83 in stock. I love the specificity of this number.
- Google now has 78k employees.