GOOG: A Particular Set of Skills

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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June 9, 2015

GOOG: A Particular Set of Skills

GOOG has levered its dominant prowess in data processing into market leadership in advertising, and plans to extend that leadership by orchestrating a mobile commerce ecosystem, with the potential to generate enormous value for itself and its partners. Investment in Search/Now, YouTube, Android, Maps, Shopping, and DoubleClick, along with initiatives like Express, Pay, FI, and Fiber, will directly support these plans, enabling advertisers to better deliver their messages and measure effectiveness through to an eventual sale, and merchants to better understand and engage their customers and potential customers. GOOG’s investments support other ambitions as well. Android leads to a range of personal and home devices – Nexus, Nest, Cardboard, etc. – that collectively have the potential to be a significant business. Similarly, Compute Engine and Docs are baby steps into an unfamiliar enterprise IT world that could one day be a massive market for GOOG’s world leading data processing technology and infrastructure. Still, there are threats to GOOG’s hegemony. EU antitrust charges could blunt advertising opportunities on that continent. AMZN and other shopping apps have taken a meaningful share of product discovery on mobile devices. FB and TWTR have done the same for media. We believe that these risks will prove far less damaging than most investors assume, and, in contrast, that GOOG’s data processing leadership will generate far more value in its current initiatives and in many initiatives to come.

  • The top data processing company by a wide margin. GOOG invented most of the major technologies underpinning modern data processing, and remains years ahead in its implementation of massively parallel, web-scale computing. Its infrastructure of networked data centers is the industry’s largest, most powerful, and cheapest. Its computer science talent is also best, with world leading capability in data center design, data management, data analytics, deep learning, and security. This prowess is GOOG’s core and greatest strength, and can be leveraged in many, many directions.
  • GOOG uniquely positioned to orchestrate m-commerce. The core Search and Android franchises position GOOG to control the ecosystem with privileged reach, engagement and user data. To one side, GOOG will reach to advertisers with new ad tech, more aggressive targeting, new formats, and improved tracking. To the other, it will reach to merchants with superior loyalty program support, payments innovation, platform reach/engagement, and merchant services like Shopping and Express Delivery. Even network investments, like Fiber and Fi, could work in support of GOOG’s m-commerce ambitions. In accelerating the progress of m-commerce GOOG expect to create value for advertisers, merchants and consumers, cementing a role for itself as an information broker and transaction facilitator – and re-establishing the primacy of its role in discovery – in the process.
  • Digital media synergistic with m-commerce. YouTube is the world’s dominant video streaming platform engaging 1B+ monthly users, but it has been curiously under-monetized to date. GOOG intends to accelerate ad revenue growth by integrating its user profiles with those generated by search, promoting popular and ad friendly exclusive programming, and extending to new platforms – subscription music, live streaming, 360 degree VR content, etc.
  • Early days in the IoT. GOOG sells a number of consumer devices – Nexus phones and tablets, Chromecast, Nest home products, Cardboard VR viewers, Glass, etc. – but collectively, these products have yet to make major contributions to the company’s top or bottom line. However, in the longer term we see substantial opportunity for GOOG to leverage its considerable technology strengths into leadership in several emerging markets. The newly announced Brillo OS, built on Android, could break the standards wars and interoperability logjam that has retarded the progress of the Internet of Things (IoT), giving GOOG, and its Nest products substantial advantage. Chromecast may portend a cloud-based side run around TV hardware. Cardboard and the just announced Jump platform for 360 degree video production is a leap to market with affordable, “good enough” virtual reality that could trump the more ambitious plans of FB and MSFT. Android Auto will start to show in vehicles this year, extending the smartphone sphere of influence, while investments in autonomous driving could pay off in different directions, from technology licensing to operating fleets of taxi/delivery vehicles.
  • Not yet serious about enterprise. As the world leader in distributed data processing technology and infrastructure, GOOG would seem to have a lot to offer in an enterprise market that is in the early phase of an exodus to the cloud. Thus far, it has offered a low priced SaaS office suite with perfunctory support for MSFT Office documents, a modestly successful corporate email product, and powerful and cheap IaaS hosting services that lack effective marketing or comprehensive customer support. GOOG can do better, and occasionally, shows signs of caring enough to follow through. We believe that GOOG would be a natural partner for a traditional IT vendor – e.g. CSCO, EMC, etc. – with strong relationships but without traction in the cloud.
  • Threats. Mobile Apps – GOOG is adapting search to deliver mobile focused results, overlaying apps with always available context aware search. Its share of ad sales is higher in mobile than on the desktop, and participates in 73% of all product research on mobile devices. Fragmentation – Stronger controls on licensees via the Google Services Mandatory program reining in platform drift and platform upgrades are rolling more smoothly. Still an issue in China, where government limits on Google services blunt their value. Government Intervention – The EU’s politically motivated investigation could weaken Google’s mobile platform and search hegemony, but remedies are expected to leave its long term strategy intact with modest financial impact. Bigger risk is on management distraction and chilling M&A, favoring a quick settlement rather than drawn out fight. Competition – GOOG’s ambitions pit it against AMZN, AAPL and FB. While these rivals are big, extraordinarily capable and aggressive, so is GOOG and the markets that they mutually address are gigantic with room for all four to grow and succeed.
  • Valuation. Trading at 16.3x forward earnings and 5.3x trailing sales, with a 1.24 PEG ratio and a 20% projected cash CAGR, GOOG is not expensive compared with its peers, with the possible exception of AAPL. In our proprietary valuation framework, GOOG’s 5th year terminal value is only 65% of its EV, with 80% of large cap TMT names carrying more robust implicit long term expectations. For a company with unchallenged leadership in cloud-based data processing positioned against multi-trillion dollar opportunities in mobile commerce, media, IoT, and enterprise, the market’s perspective is far, far too pessimistic. While it may take some time to counter the skeptical narrative that has grown around the stock, we see it is a near sure bet to maintain its strength long term.

I’ve Looked at Clouds From Both Sides Now

GOOG invented web-scale data processing. It invented the software technologies that became Hadoop, NoSQL, Open Stack, and the whole ecosystem of big data. It invented a new way to build data centers that drastically lowered costs and improved performance – innovations that were picked up by AMZN, MSFT and FB in building their own infrastructure. These big ideas, contributed to the open source community as gifts once GOOG had moved on to its own next iteration, are still being born in the company that spends nearly as much money on data centers as its three closest competitors combined, and that boasts the deepest roster of computer science geniuses on the planet. This, not search or advertising, is GOOG’s essence.

That data processing prowess stands for something in every single one of the many markets that GOOG has entered. With few exceptions, we can organize those far flung initiatives into 4 basic thrusts. Of these, it has the most irons in the Mobile Commerce fire. As one of two platforms that dominate mobile, as the dominant instrument for discovery, and as the leading channel for mobile advertising, GOOG is uniquely positioned to orchestrate an m-commerce ecosystem. With a superior combination of consumer reach, engagement and data, GOOG can help merchants build, manage and serve their community of loyal customers, help advertisers track their messages from targeting to transaction, and deliver convenience to satisfied consumers. Specific products, like Search, Now, Android Pay, Shopping, Express, AdWords, and DoubleClick, have obvious roles to play right now. Others, like Fiber, Fi, and autonomous vehicles, have option value for the future of mobile commerce. While AMZN, EBAY, and ambitious merchants like WMT, have designs on the same market, Android and Search are huge advantages for GOOG against a market opportunity addressing trillions of dollars of global retail sales.

YouTube is GOOG’s primary vehicle in Digital Media, with Google News and Play also taking roles. Even though YouTube reaches more than a billion users and streams more than 9 billion hours of video each month, quarterly revenues are estimated at just $1.5B. GOOG is expected to move to juice revenues by finally applying consumer data from Search to target ads sold for YouTube. Opportunities in the Internet of Things will be slow to emerge, but GOOG is well positioned to prosper. The Brillo OS and Weave interface spec are very strong entries to a crowded field of competing standards. Android Auto will show in several new models this year, while leadership in autonomous vehicle technology could pay off in a number of different ways in the future. Wearables are still a nascent market, but GOOG has a number of projects at work, as it does in virtual reality. Investment is also going toward connecting the Next Four Billion, expanding the reach of the Internet to new corners of the world and previously unserved demographic segments, while making sure that these users become avid users of Search, Maps, YouTube, etc.. Finally, GOOG seems to be dabbling in the Enterprise Cloud with its under-marketed Docs productivity suite and GCE IaaS platform. We think these products might gain more traction with a traditional IT company as a marketing partner.

We think the threats to GOOG’s hegemony – mobile apps, fragmentation, government intervention, and stiff competition – are a bit overplayed, particularly given the company’s formidable capabilities and the enormous size of the opportunities that it is addressing. This skepticism around GOOG shows in its valuation, trading at a lower multiple than peers with less promise despite a fairly consistent record of growth and consensus expectations for more of the same.

In Search of Excellence

The top 5 companies by market cap in TMT, all icons and each with a valuation of $200B or more, are Apple, Microsoft, Google, Facebook and Amazon. While these five routinely bump into one another in competition, Google stands out as the universal rival (Exhibit 1). Arguably, the management of each of the other four would all name it as their most dangerous competitor, testament to both Google’s extraordinary strengths and to its unusually broad strategy. Even in this crowd of deep pocketed and future focused innovators, Google stands out.

Exh 1: Areas of Competition between Major Tech Platforms

Google has taken on Apple in mobile devices, delivering for free the Android operating system in the wake of the iPhone, a lifeline to the device makers willing to take it and, now, the dominant mobile platform in the world, powering more than 3/4ths of all smartphones in use (Exhibit 2). Google battles Facebook for digital advertising, holding on to more than double its rival’s market share on both the desktop and mobile devices. The company is stepping up its competition in e-commerce with Amazon, adding a one-click buy button to its Shopping search results, integrating a payments utility into its Android platform that extends the reach of retailer loyalty programs, offering same-day deliveries for some merchants in some markets, and experimenting with autonomous vehicles that could change the economics of delivery entirely. It has also been a gadfly to both Amazon and Microsoft, leading massive price cuts for the cloud hosting services that we believe will be the future of enterprise computing.

Exh 2: Global Smartphone Installed Base by OS, December 2014

This omnipresence worries investors, who see a company patiently tending to its many initiatives and launching new ones while threats to its once unassailable search advertising business emerge and as its top line growth decelerates. To these investors, the option value of Google’s big move on mobile commerce, its play in the future of media, its interest in the Internet of Things, or its fledgling enterprise hosting platform is de minimus compared to the risks that it faces – the apps that siphon off discovery from search on mobile devices, the rise of forked versions of Android that do not use Google applications, the legal challenge in the EU, and the quality of the companies with whom Google has chosen to compete.

To us, the glass is much more than half full. The basis of that optimism comes from the part of Google that consumers and many investors do not see, its extraordinary data processing capabilities. It has the biggest, fastest, cheapest, most flexible, and furthest flung distributed data center infrastructure of any organization on the planet, investing as much as its top three rivals combined in order to keep it that way. Its software is years ahead of rivals in most web-scale tools – e.g. data management, business intelligence analytics, and deep learning. It has been the employer of choice for the best computer science talent since the turn of the millennium. In a technology era that is defined by cloud computing and mobile devices, Google dominates the first and reaches more than a billion users with its platform in the second. That is a lot of excellence.

Prepare to Be Assimilated

The genesis of Google stems back to 1996 and Larry Page’s search for a dissertation topic while studying for his Ph.D in computer science at Stanford. Page hit upon an idea to map the structure of page to page links within the World Wide Web as a mechanism to rank web pages by importance. Page brought fellow Ph.D. candidate, and friend, Sergey Brin into his project, and the two of them wrote the first version of the PageRank algorithm. Shortly thereafter, it became clear that the algorithm could be used not just to rank the importance of pages, but also to search for them, and in September 1998, Page and Brin incorporated Google, with a $100,000 check from Sun Microsystems founder Andy Becktolsheim as seed capital (Exhibit 3). In that era, portals with curated links to popular pages were still the primary way for consumers to navigate the rapidly growing web and competing search engines used relatively rudimentary and easily gamed techniques, such as counting the number of times specific words were referenced on a page to determine their page recommendations.

Exh 3: Google Major Event Timeline, Founding to IPO

Google’s approach was clearly superior and the business grew rapidly. However, Google’s growth revealed a considerable obstacle. As it evolved, PageRank was increasingly computationally intensive, while the universe of web pages that it undertook to index grew exponentially. Indeed, the name Google refers to the term for the number 10100, intended to reflect the fledgling company’s aspiration to create technology that could scale to extraordinary size and scope. To keep pace with the Internet, the capacity and performance of Google’s data processing infrastructure needed to grow beyond the limitations of the then existing IT state of the art. Realizing these implications, Page and Brin embarked to reinvent the way that computers organize problems and redesign the basic architecture of the data center.

Google, in keeping with its academic origins, was at the beginning and remains today a magnet for serious computer science talent. Two of those scientists, Drs. Jeffery Dean and Sanjay Ghemawat, invented a new way to use a programming concept called MapReduce to break large computing tasks into tiny pieces, farm them out to many processors to be solved in parallel, and then to recombine the results to a single solution. With this technique, analysis of the massive index of the billions of pages on the internet could be accomplished more quickly and accurately. In 2004, the two scientists published a technical whitepaper on their approach, already implemented within Google, inspiring the open source software community to develop a public version of the technology, named Hadoop, that remains the underpinnings of most cloud computing platforms and “big data” infrastructure software solutions (Exhibit 4).

Exh 4: MapReduce/Hadoop parallel computing flow

Google’s most recent data processing schema is called “The Borg”, after the geek classic aliens of “Star Trek: The Next Generation” fame. Analogous to its namesake, Google’s Borg collectivizes individual processors under a manager program responsible for accepting, scheduling, starting, stopping, restarting and monitoring hundreds of thousands of jobs submitted by thousands of applications and running on hundreds of clusters, each comprised tens of thousands of servers, each with multiple processors (Exhibit 5). The Borg makes resource management automatic, freeing developers and their programs from responsibility, and assures efficient utilization, as any element within a Borg that may expand across many individual data centers can be assigned to any job as needed. Supporting many applications within the same system also promotes efficiency, as low priority jobs can be scheduled to fill off-peak hours. While earlier versions of the Borg are believed to have been used within Google for the last decade, the white paper describing its concepts was only published earlier this year and open source equivalents are likely two years or more away. By then, Google will have, undoubtedly, moved on to something else.

Exh 5: Google’s “Borg” Simplified

The Oracle of Mountain View

Dr. Ghemawat was also a lead developer on Google File Systems (GFS), a software scheme that did for storage what MapReduce did for processing. In traditional data centers, storage systems ran separate from the processing systems, with their own logic to manage storage, retrieval and recovery. GFS broke files into fixed size 64MB chunks which are replicated for redundancy and distributed to “chunk servers” for storage in close physical proximity to the processors most likely to need the files. As a result, data was spread in multiple copies over multiple physical locations for high levels of reliability, storage operations were unfettered by arbitrary file or system size limitations, and storage performance was uncompromised without bottlenecks between files and processing. While Google scientists spoke in general terms about GFS and its approach to storage as early as 2003, this technology has not been contributed to the open source community.

In 2010, Google announced that it was replacing GFS with a new storage system code named “Colossus”. This system eliminated a single point of failure in GFS, greatly improving its reliability. It also operates in real time, allowing on the fly updates that make for more current search results, amongst other implications for its web applications. Furthermore, it breaks files into smaller chunks than GFS, allowing for a step-function improvement in the efficiency of storage.

Google also broke new ground with its approach to data base management systems (DBMS). Commercial DBMS, led by Oracle, is embedded as supporting infrastructure for a large majority of enterprise applications. These software systems are rigid in nature, requiring precise preset data formats, structured queries, and strict limitations on the size of data entries and the number of records. This rigidity did not suit Google’s needs, prompting it to begin developing its own DBMS in early 2004. The result, called BigTable, was put into service in February 2005, underpinning Google’s web indexing and enabling a variety of its services, from Gmail to Maps and YouTube, to scale beyond arbitrary limits, without taxing performance or reliability. Like MapReduce before it, the basic tenets of BigTable were contributed to the open source community a few years later, inspiring the popular HBase standard.

Exh 6: Google’s technologies work in concert to power the world’s most powerful distributed computing platform

BigTable was followed by Spanner in 2012. Google’s scientists reasoned that the primary vulnerability of distributed systems like MapReduce and BigTable was actually keeping accurate time. True DBMS were able to promise certainty in data integrity by keeping it simple – one master file adjudicated time stamps so that the system KNEW the order in which commands had been issued. For trades on an exchange or tickets in a reservation system, ambiguity was unacceptable. Unfortunately, distributed data base systems, where data may be stored across multiple geographic locations, traditionally maintained relative timing from a central source, which could introduce ambiguity as latency and error could offset relative timing at occasional intervals. To this end, Google implemented atomic clocks and precise GPS reckoning at each of its locations, a system it calls TruTime, eliminating the potential for a time based anomaly (Exhibit 6). Spanner is free to spread data bases across multiple locations, improving its resilience to failure and increasing the speed of access. The result is extremely fast, extremely flexible, limitlessly scalable, real time and of great integrity.

You Get What You Need

The original PageRank algorithm began a tireless march of search innovation, increasing the currency and completeness of Google’s web index while speeding the delivery of relevant results. The 2009 transition to a new architecture, code named “caffeine”, brought real time search, exploiting the Colossus architecture to tap into immediate updates, anticipate queries and deliver results faster than users could finish typing. In 2013, Google announced a transition to yet another search architecture, called “Hummingbird” that incorporated deep machine learning to process natural language queries more accurately, to anticipate user needs, and to deliver answers rather than just links. A further extension of Hummingbird was Google Now, the mobile service that delivers content deemed likely to be of interest based on data gleaned from prior searches, calendar items, e-mail contents, and other data points available to it. With Now, Google has moved from reacting to requests to anticipating needs, strengthening its role in user discovery.

Infrastructure

Harder, Better, Faster, Stronger

Google’s revolutionary innovations in infrastructure software are matched by its dramatic reworking of the tired data center architecture that has persisted since the late ‘80’s. This new paradigm has substantial cost and performance advantages, which we codify into seven factors: 1) Use of commodity components vs. value-added configured systems; 2) Minimal non-productive costs; 3) Much higher utilization; 4) Superior system availability and recovery; 5) Very low personnel costs; 6) Flexibility, scalability, power and convenience; 7) Substantial economies of scale (Exhibit 7). These factors enable as much as 90% lower all-in costs relative to the typical enterprise data center based on virtualized client-server architecture, and as much as a 50% advantages over less sophisticated operations applying Google’s paradigm on a smaller scale.

Exh 7: The 7 Advantages of Cloud Infrastructure

Use of commodity components. By buying chips and drives directly from component manufacturers and having them installed onto circuit boards of their own design by low cost contract manufacturers, Google eliminated costly hardware bells and whistles, unnecessary software, and system vendor margins from their equipment investment (Exhibit 8). Moreover, other elements of hardware have been eliminated or replaced with cheaper alternatives – for example, open racks allow for minimal systems cooling hardware and commodity data switches can replace high cost routers. All together, we believe Google’s hardware costs per unit of processing capacity may be as much as 50% lower than even large scale data centers built out with configured systems. We also note that Google owns tens of thousands of miles of fiber optic cable connecting its data center locations, greatly reducing costs in comparison to leasing such lines from network operators or using commercial telecommunications services.

Exh 8: Server / component cost comparison

Minimal non-productive costs. Traditional data centers are designed to avoid failure. Cooling systems maintain components within temperatures optimal for performance, while power management systems work to ensure the constant availability of electricity. This is expensive – the costs of this environmental infrastructure are as much as 25% of the non-personnel costs of a data center. Google’s data center design dispenses with as much of this cost as possible, allowing data centers to operate outside of “optimal” parameters for temperature and power consistency. While this yields greater failure of components, Google’s data centers are designed to accommodate it with storage redundancy and the fast reassignment of workloads to working processors. The failed boards are then simply replaced. Not only does this dramatically reduce the investment in environmental infrastructure, but it also cuts the power draw of the data center as well. Electricity is more than 15% of non-personnel costs for the average data center, with power for environmental control, power conditioning, lighting and other non-productive uses amounting to more than 80% of that needed for computing, storage and networking. This ratio, known as Power Usage Effectiveness (PUE) and expressed as the power drawn relative to the amount needed for productive uses, shows top cloud operators at a distinct advantage (Exhibit 9). For example, Google’s mean self-reported PUE for its data centers is 1.11 vs. the 1.80 enterprise average, and includes a broader range of non-computing power use categories than is normally reported. Using the less rigorous metrics applied by most other data center operators, Google notes that its PUE could be as low as 1.06 and has been trending down steadily over the 6 years that it has reported the number. Beyond PUE, it is also likely true that Google is much more efficient in the use of power for productive purposes as well. Overall, it adds to as much as a 50% advantage in electricity costs, a 25% advantage in non-personnel operating costs and a ~10% advantage in the all-in costs of computing.

Exh 9: Calculating Power Usage Effectiveness (PUE)

Higher Utilization. Many of the costs of a data center are fixed – hardware and software investment, facilities costs, some personnel, etc. The more that the data center is utilized, the more broadly these costs can be amortized against productive work. Google is able to run effectively at higher levels of utilization, as its size and the broad mix of applications that they serve statistically tighten the degree of slack capacity necessary to handle peak demand. Moreover, the flexible nature of the “Borg” software architecture (workloads can be easily shifted from location to location to balance utilization), optimized hardware configurations (the commercial systems used in typical data centers may “waste” capacity if the CPU, memory, storage, etc. do not ideally fit the applications being run), the base load demand from Search and Google’s other huge consumer cloud franchises, and its global reach, also help it maintain higher average utilization. Google has reported that its data centers run at an average 30% capacity utilization, nearly 3 times the 12% enterprise data center average that has been calculated by Gartner, amongst others. This factor alone could give Google as much as 60% cost advantage for computing and storage workloads (Exhibit 10).

Exh 10: Server Utilization Rates

Exh 11: Cloud provider Service Level Guarantees

Superior availability and recovery. Data center capacity occasionally goes out of service, both for planned reasons and for unanticipated outages (Exhibit 11). Downtime is costly, requiring work to be shifted to alternative capacity or delayed while expensive systems engineers execute the necessary steps to bring the systems back into service. Google’s cloud architecture is designed to handle system upgrades and maintenance with less planned downtime, while having fewer unplanned outages and recovering from them more quickly than enterprise data centers. Google also has the advantage of geographic diversity, with data typically stored redundantly at multiple locations. Processing loads and network communications can automatically shift to alternative, available data centers should any one site suffer failure. All of this is handled in the system software infrastructure, saving the cost and complexity of functionally specific back-up systems, such as RAID storage. With these techniques, Google can offer lower systemic risk to customer data than within traditional data centers at a lower overall cost. The overall cost impact of this impact, including the staffing and consulting support needed to respond to outages, is very difficult to quantify but it is a real advantage.

Very low personnel costs. Google’s data centers are highly automated and monitored remotely. Anecdotal reports suggest that Google may be operating data centers of 100,000 servers or more with IT staffs of fewer than 20, implying an impressive 1/5,000 ratio, far better than the 1/1000 reported by rival Microsoft (Exhibit 12). In contrast, even in a well-run in-house enterprise data center automation is minimal and human error causes considerable error. The IT staff to server ratio at a traditional enterprise data center typically runs at an expensive 1/100. For such organizations, personnel can make up 30-50% of total data center operating costs. By comparison, data center operations personnel costs for any of the top IaaS players is less than 5% of the total, with Google likely a fraction of that.

Exh 12: Web-scale data center cost distribution

Flexibility, scalability, power and convenience. Beyond integrated backup, the web-scale approach of cloud architecture also offers valuable benefits to commercial customers – no practical limits on application scale, ability to accommodate enormous short term usage spikes, predictable all-in pay-as-you-go pricing, global scope, automatic system upgrades, world-class IT support and maintenance, and many others. To illustrate one of these advantages, Google’s Senior Vice President of Infrastructure, Urs Hotzel, demoed the capabilities of the company’s Compute Engine hosting service during the 2012 I/O developers conference, employing more than 750,000 server cores in parallel to complete an analysis of a human genome in less than a minute, vs. the 15 hours that it usually took on the customer’s own computing infrastructure. The combination of enormous power, complete usage flexibility and all inclusive pricing, available on a global basis with little previous notice is a powerful selling proposition. We note that the top cloud operators (including Facebook, which has not shown interest in applying its infrastructure to the commercial IaaS market) have been the employers of choice for the most talented computer scientists over the last decade, and that the R&D excellence that this talent represents will only push the proprietary implementations of cloud architecture further ahead in the future.

Economies of scale.

According to Analysys Mason, Google spent $6.5B of its $11B in 2014 capex directly on computing and communications infrastructure (Exhibit 13). By contrast, second place spender Microsoft just $2.5B of its $5.3B capex on infrastructure, while number three Facebook spent $1.2B of its $1.8B capex on the same. Amazon, with massive investments in fulfillment centers for its e-tail business underway, spent less than $1B of its $4.9B capital spend on data centers. Google’s data center spending was greater than the next four spenders (Ebay was 4th) combined, and accounted for a whopping 20% of all estimated spending by public cloud operators. Apple, a relative newbie to data center investment, spent just $750M in 2014.

Exh 13: 2014 Capex Dedicated to Datacenter Computing Infrastructure

If the ratio of data center spending to total capex has remained fairly constant, Google is working with more than $14B in undepreciated data center assets, well more than double the $6.4B estimated for Microsoft on the same basis. Amazon, spending just 20% of its capex on its cloud infrastructure, has $3.4B in computing and communications assets. Facebook, which devotes the highest percentage of its capex to infrastructure investment, has an estimated $3.1B in cumulative net data center spending.

For data systems costs, bigger is definitely better. Technology is purchased more cheaply in bulk. Personnel and other development costs can be levered over a much larger base. Scale enables greater geographic dispersion and justifies dedicated fiber connections, both of which reduce telecom costs. Large operations can buy their own real estate, better suited to the needs of a data center and cheaper to boot. The best in IT talent is attracted to the challenges at the cutting edge, and can be leveraged across a massive base of IT driven business. Custom hardware and software development makes sense when applied to lucrative consumer cloud franchises and can be utilized in the hosting business as well.

Going Where No One Can Follow

Google’s distributed data center infrastructure affords it advantages, far beyond cost, that show up in nearly every one of its products. Google Now is an excellent example, using Google’s machine learning capabilities to find content likely to be of use to individual users, based on analyses of searches, locations visited, calendar appointments, Gmail correspondence, etc.. The recently announced Now on Tap extends this prescience into 3rd party apps, allowing Android users to summon contextual support and information while remaining in the app. This is supported by the best voice recognition in the market – Google reports that word errors have fallen from 23% in 2013 to less than 8% today. All of this derives from Google’s superior data processing capabilities and no other companies, including Apple, have the wherewithal to match the functionality.

The Google Photos app announced at the recent I/O developers conference is another technical tour de force. Photos allows users on Android or iPhones to store an unlimited number of photos and videos for free on Google’s cloud, offering sophisticated tools that use deep learning technology to sort images based on who in in them, where they were taken, when they were taken or even thematic aspects of the shot – e.g. pictures with mountains in them, or pictures of cats. Google can make the product unlimited and free because of the extraordinarily low cost of its storage, and because it hopes that the additional data points that it can add to its user profiles by virtue of analyzing those photos will be more than worth it to future advertisers. It also hopes that by offering one more superior service that Apple cannot provide will give it greater lock in with iOS users and an important obstacle for Apple as it looks to marginalize Google services within its customer base.

Maps are one more case in point. Google released Maps in mid-2005, a competitor to the already well established MapQuest application, relying on the same licensed NavTech and TeleNav map data used by GPS device makers like Garmin and TomTom. Google’s first innovation was integrating satellite photo images from its Google Earth application with its Maps. Google then launched its own fleet of data recording vehicles to wean itself from the licensed map data, collecting a far more extensive data set along the way, including panoramic 360 degree images which were subsequently added to Maps as Street View. The proprietary mapping data was combined with comprehensive image files and meticulously scrubbed for errors and inconsistencies to create a data base that is reputedly more than 20 petabytes in size and updated on a daily basis. Recently, Google added data culled from its legion of mobile users to provide insights on traffic density, average speeds, and other real-time stats relevant to travelers, augmented by its acquisition of popular mobile app Waze.

Moonshots

Google thinks broadly about how it can exploit its enormous advantages in data processing infrastructure and in its extraordinary capacity to solve the most difficult computer science problems (Exhibit 14). This mindset is central to the company’s culture, and sees it devoting resources to futurist initiatives, such as autonomous cars, wireless service provided via balloons, genetic research into longevity, and robots. Google enters into these research projects without specific monetization expectations, believing that in delivering important technology first and best will cause monetization opportunities to emerge. This approach infuriates investors, but it speaks to the limitless ambition that keeps all of that talent excited to work for the company. Arguable, Larry Page and Sergei Brin’s original audacious project to index and search the entire world-wide web was Google’s first moonshot, and look how that turned out.

Exh 14: Google’s Quarterly R&D Spend, 1Q03-1Q15

Monetization

Money Matters

This is not to say that Google doesn’t care about monetization, just that it does not believe in force fitting a monetization model on its R&D too early in the process. Indeed, Google has the opportunity to think broadly because of its success in monetizing Search and YouTube, and has clear options for expanding its monetization over the next few years. We organize those options into five distinct spheres operation: Mobile Commerce, Digital Media, Devices/Internet of Things, The Next Four Billion and Enterprise.

Mobile Commerce

We recently wrote about the emergence of m-commerce (http://www.ssrllc.com/wp-content/uploads//ftr/15.04.15-AAPL-GOOGL-Commerce.pdf). The basics of the business-to-consumer (B2C) commerce – brands pushing demand for their products via media advertising, retail merchants pulling it into their stores the same way, and coordinating with each other behind the scenes – were first challenged by desktop e-commerce. Electronic media fronted and displaced much traditional media, changing the way that consumers discovered new products and researched potential purchases. E-tailers arose with nearly limitless choice, home sofa convenience and advantaged costs to attack category after category. Same day delivery options began to chip away at the timeliness that remained a brick-and-mortar advantage. Still, despite making painful inroads, e-commerce tops 25% of total purchasing in only a couple of categories, remaining below 10% for most categories (Exhibit 15)

Exh 15: US E-Commerce Penetration by Category

M-commerce takes this further. The rapid rise of smartphones extends the reach of online services from only at home to anywhere and anytime. This corresponds to a significant increase in the time spent online, as a combination of penetration, network performance, and improved device functionality have pushed the smartphone into position as the primary conduit between consumers and the Internet. Mobile commerce, or m-commerce, has the potential not just to make online spending more convenient, but to bridge the gap between classic desktop e-commerce, as users carry their phones into the brick-and-mortar stores that still make up 93% of purchases (Exhibit 16).

Exh 16: U.S. e-Commerce quarterly sales and share of all retail, Q1 2000- Q4 2014

The potential spoils are huge. U.S. retail is a $4.7T industry, according to e-marketer, and a $22T global market. Google is focusing on clear opportunities to accelerate the development of mobile commerce and to drive value for stake holders at every step of the process.

Android. Google has interesting products and initiatives addressing almost every element of the emerging m-commerce cycle, beginning with Android. The smartphone is the unavoidable constant of mobile commerce, and the operating platform has enormous power over how consumers use their devices and how 3rd parties may interact with them. Google has set a number of its services as mandatory for its licensees – Search, Maps, the Play Store, Android Pay, Drive, YouTube and others – and setting them as defaults. 3rd party alternatives are allowed, but adding them and overriding default settings is cumbersome and rarely attempted by consumers. Brands and merchants hoping to transact with consumers via their Android smartphones have little choice but to come through Google, which controls App distribution and sets the rules for app interactions.

Search/Now. Google is also buttressing its hold over product discovery. Despite the investor narrative that asserts that apps are weakening the Search franchise in mobile, Google has maintained a higher share of total advertising spending in mobile than it does on the desktop. Google’s own research shows that 48% of product research performed on mobile devices begins with Search, and that 73% of all product research includes Search along the way. The prominence of Google Now, which anticipates user needs and interests and presents contextually useful content, greatly strengthens the core search product by pre-empting it. At the recent I/O conference, Google extended this to allow Android users to summon contextual help from Search while in the midst of using 3rd party apps.

AdWords/DoubleClick. To date, Google has maintained a far more conservative privacy policy than its primary mobile ad rival, Facebook, keeping the consumer profile data generated by each of its franchises separated. This has been to the great benefit of Facebook, whose aggressive use of profile data is decried by consumer advocates but overwhelmingly accepted by the consumers themselves. Google is expected to launch targeting tools that incorporate the whole of the company’s consumer data later this year, boosting the value of its ads. In addition, we expect Google’s push to support retail loyalty programs to allow it to track advertising effectiveness all of the way to purchase at select partner merchant, delivering on a premise that has been the Holy Grail throughout the history of digital advertising.

Exh 17: Apple Pay Adoption by Survey, “Tried at least once”

Android Pay. To date, the consumer response to mobile payments has been a resounding “meh”. Even the widely hyped ApplePay has seen just 15% of iPhone6 and 6 Plus owners even try the service, with only 6% becoming regular users (Exhibit 17). On their own, mobile payments add little benefit to either merchants or consumers. They must be integrated into a rethinking of the shopping experience, a process that will take time to play out. Google is looking to accelerate that process in a few ways. First, it is looking to work closely to extend merchant loyalty programs into the digital realm. Retailers lack the profile information and reach to engage customers effectively on line – Google can match loyalty program members to its own user profiles, helping to both anticipate the needs of existing members and identify non-members likely to be interested. Through Google Now, merchants will also be able to reach interested consumers at times and in places when they are most likely to buy. For consumers, Google is in beta tests with a hands free m-payments capability that will allow them to complete secure transactions without even pulling out their smartphone. This technology has the potential to untether transactions from POS queues, entirely transforming the checkout experience.

Exh 18: Starbucks Weekly Mobile Transactions and Active Users, 4Q12 – 1Q15

We note that some retailers, notably Starbucks, have had success with their own loyalty apps with integrated mobile payments, and that others, including the massive MCX consortium, seem hell bent on pushing to their own independent solutions (Exhibit 18). While Starbucks, with its tech savvy customer base, its market leading visit frequency, and early mover status, has been an unqualified success, we believe that most merchants will find mobile a tough row to hoe. In an average month, the average smartphone owner uses just 26 apps, and just a third of those owners will download even a single new app. Of the new apps that get downloaded, more than 80% are abandoned after their first use. MCX will ask its shoppers to use those apps to pay via a multistep POS process involving downloaded, scan-able QR codes. Adding in the dismal history of tech industry consortia, we (the SSR TMT team) are not optimistic.

Maps. Google Maps has already been an enormous boon to retailers, powering “store finder” apps, posting merchant logos on maps being used for navigation for a fee, etc. There are important ways in which the value of Maps may increase with the rise of m-commerce. For example, many thought pieces on the future of retail tout the potential of pushing advertising to loyalty customers when they are in the vicinity of a store – this potential application is dependent on Maps data. Historical Maps data may be used to help target advertising, or identify frequent visitors who have not signed on for loyalty programs.

Shopping/Express. Google has tried hard to position itself as the merchant friendly alternative to Amazon Marketplace, where traditional merchants list their products in direct competition with the e-commerce titan’s own offerings. Google Shopping presents product searchers with offers direct from merchants, who pay fees to be included amongst the results for their products. In 2013, Google launched Express, a same-day delivery service for customers in Silicon Valley and San Francisco, extending it to New York and Los Angeles in 2014, and to Chicago, Boston and Washington D.C. earlier this year. For merchant partners in these markets, Express fills in a service gap vs. Amazon which has also been rolling out same-day deliveries. Later this year, Google is expected to add a “Buy Now” button for its Shopping service, allowing consumers to check out with specific retailers in a single click and filling in another convenience gap vs. Amazon.

The Whole Nine Yards. Taken in total, Google’s m-commerce related businesses and initiatives place it in a unique position to create value for the major stakeholders around the cycle – product purveyors, consumers and retailers – enhancing information flows, removing transaction friction and improving the shopping experience. Even seemingly extraneous investments, say Google Fi, Fiber or even autonomous vehicles, could eventually fit into a theme of facilitating commerce.

Digital Media

Google has been curiously coy about the number of active YouTube viewers, affirming only that it has more than 1 billion monthly visitors (and has for more than two years) (Exhibit 19). Given the popularity of the service in markets with rapid mobile user growth, it is fairly certain that YouTube trails only Facebook and its 1.4B MAUs, and perhaps trails by less than most would assume. It is likely that YouTube streams more than 9 billion hours of video each month, making it, by far, the world’s number one streaming video service. N.B. Netflix announced in April that it streamed 10 billion hours of video over the course of the first quarter, or about 3.3 billion hours monthly.

Despite this extraordinary reach and engagement, YouTube revenues, which are not broken out by Google, are believed to be in the range of $1.5B per quarter. Google aims to do considerably better than that. One lever to do that is the aforementioned move to apply the user profiles from Search toward targeting advertising on YouTube. Another is promoting the service’s most popular content providers to build the regular, predictable audiences that appeal to advertisers weaned on weekly TV, giving those content providers strong incentive to stay loyal to YouTube in the process. At the same time, we believe that demand for television advertising is peaking, as years of declining ratings and the deteriorating quality of viewership catch up to the networks. YouTube is a logical beneficiary of the shift, as its closest rival for reach and engagement, Netflix, operates on a strictly subscription basis.

Exh 19: SSR Calculated Streaming per US Viewer, Q1 2015

Music has been a key market for YouTube, with more global users relying on it for listening than Apple iTunes, Spotify and Pandora combined. It has become a key venue for the discovery of new artists, breaking acts like Justin Bieber and Austin Mahone before they had signed to major labels. Recently, Google added a subscription service, allowing users to pay for ad-free music, along with a freemium version that bunches advertising while promoting whole album listening. This may be another step to better monetization of the platform, at a time when the shift from music buying to music subscribing seems to have passed the tipping point.

Live programming and pay-per-view services are also potential money makers for Google’s video platform. It was the first streaming service to step in when the Sony hacking scandal forced cancellation of its controversial “The Interview”. It set records for the live stream of daredevil Felix Baumgartner’s parachute jump from the edge of space, with plans to push its Live Events strongly into the increasingly lucrative market for e-sports and gaming, currently led by recent Amazon acquisition Twitch. Unlike Netflix and Amazon, Google has not moved into producing its own original content, instead supporting its many content partners with promotion, production facilities, and other support. On a longer term basis, Google’s technology for the production of low-cost 360 degree virtual reality videos and its support of those videos on YouTube could give it an important head start vs. more sophisticated and much higher cost alternatives being developed by Facebook and Microsoft.

Finally, Google Play certainly participates in the distribution of digital media, offering its own curated music streaming service, video downloads, e-books, e-magazines, games and apps. While Play has historically been portrayed as a weak sister to Apple’s iTunes, of late it has picked up steam. While on average, Android users have been far less enthusiastic shoppers than iOS users, there are so many more of them that overall app spending on Play has surpassed Apple’s App Store, on a trajectory to quickly widen the gap. This has the benefit of drawing more developers to Android, and because Google’s total revenues are just over 25% of Apple’s, the business is more likely to be a significant contributor to sales and earnings growth.

Exh 20: iOS versus Android Apps and Features

Devices and the Internet of Things (IoT)

Google makes a range of consumer devices. Some of these, like the disappointing Glass or the surprising Cardboard, are experiments released into the wild to see how they work in the real world. Others, specifically the Nexus program and Project ARA (modular phones), are intended to serve as best practice examples and proofs of concept to OEM partners, helping to drive the whole ecosystem forward. Still others, such as the networked residential products made by the recently acquired Nest or the affordable video streamer Chromecast, are fully realized products, neither experiments nor punches pulled in effort to spare licensees.

This grab bag of devices represents serious innovation and offers significant options for Google to make money in the future. Most of these efforts are now spearheaded by former Nest CEO Tony Fadel, touted as the design father of the original iPod during a prior career at Apple. Fadel’s objectives and strategies are fairly opaque, but given his known passions for design and his continued, apparently enthusiastic, employment, one can expect that he is driving to a broader range of Google devices.

Smart Homes. The Nest thermostats, fire alarms, and nanny cams are part of an emerging market for the smart home that includes other categories, such as smart locks, smart lighting, smart entertainment systems, and smart appliances. The problem is that the market has been emerging for a long time, held up by competing standards and vicious turf wars amongst the many stakeholders in what is now usually called “The Internet of Things”. Practically, the smart home today is not so smart – the locks don’t really coordinate with the lights, which don’t dance with the entertainment, which won’t talk to the appliances, the thermostats or the fire alarms.

Google wants to fix that, in the process boosting adoption of its own smart home devices and promoting Android devices as the control mechanism for consumers. At its recent I/O conference, Google announced the Brillo operating system, a stripped down, low power version of Android offered for free to makers of smart home devices. Companies adopting Brillo would benefit from not having to develop and evolve their own OS, and from running a standard platform that could accommodate 3rd party applications and facilitate the coordination of applications across multiple devices. Atop Brillo, Google also announced Weave, a communications standard to enable requests and commands between devices within a connected home. Brillo and Weave add to Thread, a previously released Google standard for low powered wireless connections between devices.

Exh 21: Internet of Things Standards Bodies and Memberships

Compared to alternatives in the market, Google’s solutions are innovative and complete. The ZigBee Alliance was first to market, and focuses specifically on the wireless connections addressed by Thread. While widely adopted, ZigBee has been greatly limited by its requirement for separate logical networks for each application – lighting system components are separated from entertainment etc. – stifling initiatives to manage home systems in concert. The new ZigBee 3.0 standard finally removes this limitation, but we note that it is merely a wireless protocol without a standard like Weave to establish a common command language between devices. Other initiatives, notably the Qualcomm led AllJoyn and the Intel led Open Interconnect, have shown more ambition in this area but have been bogged down by bitter rivalry, similar to and perhaps, more evenly matched, than the VHS/BetaMax video tape battles of the ‘80s (Exhibit 21).

Apple’s HomeKit has similar ambitions to Weave, imagining a common schematic that would allow all automated home devices to be controlled from an iOS device. HomeKit will be appealing to device makers, who covet access to the well-heeled Apple customer base, but is obviously limited to committed Apple households. We also note that Apple’s track record for managing partnerships has not been particularly successful, perhaps leaving room for the more collegial Google to gain better traction with device makers, even if Google intends to compete with, at least, some of them (Exhibit 22).

Exh 22: Connected Home Device Unit Shipment Forecast, 2013-2020

Nest has an announcement scheduled for June 17. In addition to revamped versions of the three existing products and an embrace of Brillo and Weave, we suspect there may be something new. A voice command driven front end to home audio systems, including wireless speakers? A connected doorbell and door lock that tie into a cloud-based and self-installed security service in concert with Dropcam and Protect? There are real possibilities.

Smart Cars. Google’s ambitions in IoT extends to the automobile as well, where its Android Auto solution extending a smartphone user’s Android services into a Car’s infotainment system. Here we expect Google to battle to a draw with Apple, and its CarPlay system, with very, very few car makers likely to enable one and not the other. Arguably, this is a far greater benefit for Google, which sees its apps used on both iPhones and Androids, collects valuable user data about user behavior in the car, and can monetize via advertising delivered through the automobile connection.

Google famously has other ambitions in the automotive world. The company’s first self-driving cars hit the California roads in 2012 and have logged more than 1.7 million miles since with only 12 total accidents, none of which could be reasonably blamed on the Google vehicles. While major automakers – Ford, Audi, Toyota, Mercedes, BMW and others – have demonstrated their own efforts at autonomous vehicles, none has come as far, or challenged the standard automotive paradigm as vigorously, as Google. The general consensus amongst the industry is that self-driving vehicles will hit the market by around 2020, so what role will Google play? There are 3 apparent avenues: 1) Google could license its technology to traditional car makers; 2) Google could produce and sell self-driving cars alone or in partnership; and/or 3) Google could use autonomous vehicles built to its specs as part of a delivery/taxi service to challenge Uber and Amazon on their own home turf. While all are possible, we would bet on #3.

Wearables. Android Wear, announced in 2013 and delivered last year, was a pragmatic response to the market hype around smartwatches that built in anticipation of the Apple Watch. We have never been overly excited about the utility of a smartwatch, as none of the use cases – even those breathlessly spoke of in the context of the Apple Watch – really seem to drive much value for the large majority of smartphone owners. Still, Google has its oar in the water, ready to row harder if Apple’s gambit builds real demand amongst Android owners for a closer analogy.

Google seems to have put more of its chips on Glass, a losing bet in the first round, but perhaps a better bet for industrial applications – e.g. heads up and hands free displays for workers who would benefit from such. It may also be that a new iteration, this time without the creepy hidden photo/video capability, could deliver more compelling use cases and reverse the fiercely negative stigma that plagued Glass 1.0. Some of the same mentality seems behind Jacquard – the conductive textile yarn just introduced at I/O 15. With Jacquard, sensors and controls could be woven directly into fabric, allowing wearers to interact with electronic devices through their clothes, upholstery, drapes, linens or other cloth, and for those fabrics to sense their own surroundings and report back. Applications like a smartphone control panel in a ski parka, or drapes that close themselves when the sun gets too intense become possible.

The Next Four Billion

Estimates of the total world population with access to the internet topped 3 billion in 2014, with nearly 2 billion of those connected by smartphone. In Google’s perspective, this means that 4 billion people do not yet have internet access and 5 billion do not own a smartphone. While these people are, on average, considerably less wealthy than the global cohort of users, their sheer number make them intriguing as a market, assuming that they can be reached very, very cheaply. Google is working to find ways to make low-cost wireless internet connectivity available to as much of the world as possible, and to set a roadmap for ever cheaper smartphones that can deliver a full suite of Google applications. These users could be a target for local advertising, and would contribute significant data on global trends amongst some of the most difficult to track segments of the global population.

The salient piece of the program is Android One, a Google defined, turn-key reference design for $100 smartphones capable of supporting the latest version of Android. This allows OEMs to minimize their own design costs and to get new products to market quickly. The products also tout Android 5.0 Lollipop features designed specifically to appeal to low income customers – e.g. a Chrome compression engine that reduces the amount of bandwidth needed for webpages, off-line support on YouTube and Maps, and fast charging for users who may have intermittent access to electricity. The first Android One products went on sale in November 2014 in India, with Bangladesh, Nepal, and Sri Lanka coming on shortly after, with products from Karbonn, Spice and Micromax, three fast growing Indian manufacturers. Early in 2015, new Android One models launched in Indonesia and the Philippines, with a Turkish model coming on in May. The products in Bangladesh, Indonesia and the Philippines are manufactured by local companies in each market and sold in close cooperation with carriers.

Google is also looking to connect would-be users in geographies that are not well served by the global cellular infrastructure. Project Loon is developing a low cost cellular standard service solution that connects to users via balloons, while the recently acquired Titan, which builds solar powered drones to do the same thing, could prove complementary. The balloons are likely to be cheaper and have a bigger footprint, but are prone to drift, while the drones can cover a specific, high traffic area more reliably. Google plans to coordinate the deployment of these technologies with ground carriers to provide seamless handoff to users traveling into areas of terrestrial coverage.

Exh 23: Worldwide Cloud Infrastructure Services Forecast, 2010-20 CAGR: 41.7%

Enterprise

From the start, Google has primarily focused on consumer applications, primarily monetizing via ad driven products and services. However, it has had its toe in the enterprise market ever since 2002, when it released the Google Search Appliance, a yellow box containing a server that indexes content by “crawling” company resources. Google still offers the Search Appliance, at an undisclosed price, and has since offered a range of other products aimed at the enterprise, in three main categories: Cloud Apps, such as Gmail and Google Docs; Cloud Services, such as App Engine (PaaS) and Compute Engine (IaaS); and devices, such as Chromebooks and Chromebox (used to set up kiosks or digital signage).

Each of the enterprise services leverages Google’s existing infrastructure and incrementally costs the company little to offer. Google likes to boast that some 5M businesses are using Google applications, and that 64% of the Fortune 500 are Google at Work customers, but its monetization of its enterprise initiatives has been weak. These businesses are included in the “other revenue” segment that makes up 10% of Google’s total sales, much of which is likely coming from miscellaneous consumer businesses, like the Play Store, Nexus, Chromebooks, Fiber and Nest, which also fall into the bucket. It is likely that all of Google’s enterprise revenue remains in the low single digit billions of dollars. This is a tiny drop in the multi-trillion dollar ocean of global enterprise IT spending.

Google knows that it should do better than that. It has begun making high profile hires from traditional IT stalwarts, like Oracle, Microsoft, Cisco and IBM, and has rebranded the whole business as “Google at Work”. We believe that its highest potential role will likely be as an IaaS host, in competition with Amazon Web Services and Microsoft Azure, leveraging its enormous lead in data center scale, cost and speed. Still, Google still faces a hurdle in getting its enterprise products in front of corporate IT departments, with their longstanding business relationships with the traditional enterprise IT vendors. Google has begun to provide better incentives for its 3rd party Value Added Reseller partners, boosting their commission to 30% of the sale rather than the customary 20%, and has been aggressive in cutting the prices on its cloud products.

Still, there is a risk that the enterprise market could get away from Google while it methodically addresses its relative weaknesses. We believe that it would be better off in negotiating a strategic partnership (or multiple strategic partnership) with traditional IT vendors, such as Cisco, EMC or HP, that have strong customer relationships but poor traction in cloud services.

Adding it Up

Google’s five major investment arenas – M-commerce, Digital Media, Devices/IoT, The Next Four Billion, and Enterprise – offer huge potential long term rewards. In M-commerce, Google offers significant value to the $4.7T US retail industry, and, given its worldwide footprint, can aspire to address the $22T global market. In Digital Media, Google services can address not just the $500B in global spending on measured media adverting, but an additional $1T+ in other advertising and marketing spend. The McKinsey Global Institute believes that the global opportunities created by IoT may be as much as $6.2T by 2025, with the number of connected objects tripling from as many as 10 billion today, to as many as 30 billion by 2020. The Next Four Billion users have a more amorphous value, but even gaining as little as $5 per year from this massive population would be a $20B opportunity. Finally, Enterprise IT is a $3T+ global market, where Google (along with Microsoft and Amazon) could play a transformative role. Factor in the option value from investments in personal transportation, robotics, health care and other areas, and Google’s long term potential addressable market is mind boggling (Exhibit 24).

Exh 24: Selected Google Market Opportunities

Threats

What Doesn’t Kill You, Makes You Stronger

Like almost any other company that competes in a fast growing and rapidly evolving business, Google faces threats. Of the pages of risks laid out in the company’s 10Ks, there are four that seem to have captured the attention of investors: Mobile AppsUnlike the desktop, mobile devices allow users one-click access to their favorite apps. Google bears worry that these focused apps will draw valuable discovery functionality away from the more generalized search application. Fragmentation – OEM licensees have historically taken liberties with the basic Android operating platform in efforts to differentiate their products from other licensees. These liberties have often siphoned users away from Google’s money making default apps and have added time and money obstacles to the process of distributing updates to the core software. Government Intervention – Google faces antitrust charges in Europe over its Search advertising and its mandatory apps for licensees. It is also effectively blocked by many repressive governments. Competition – Google is in direct and vigorous competition with some of the most capable companies on earth – i.e. Apple, Amazon, Facebook, and Microsoft.

Mobile Apps

The narrative goes like this: “The Google Search franchise was built for the desktop, where it is built in the browser command bar and users are accustomed to beginning their exploration of the internet with a search. On mobile devices, users are much more prone to begin discovery by going right to a specialized app.” If true, the value of search on a mobile device to advertisers might never be as great as it is on desktops. The questions are “is it true” and “what is Google going to do about it?”

It’s Not Really True. Google has sponsored research that purports to show the value of Mobile Search. According to its published paper, 48% of all product oriented research on mobile devices begins as a search, and 73% of product discovery on mobile includes search at some point in the buying process. Certainly self-serving, but also possibly indicative that news of Google Search’s death may be premature. We also note that the search activity most vulnerable to mobile apps is low value URL completion searches, where the user has a destination in mind, but has forgotten the web address or is too lazy to type it in completely. We also note that Google’s near 50% share of mobile ad dollars is nearly 1000 bp higher than its share of desktop digital advertising, a fact in defiance of that bearish narrative.

App Indexing. Since 2013, Google has indexed the content available through most of the apps available on Android and provided deep links directly to relevant information directly within search results. At its recent I/O conference, Google extended its App Index program to the iOS platform, positioning search as a meta-discovery solution across both major mobile device programs. While some apps choose not to participate, notably Amazon and Apple’s iTunes, Google’s index contains more than 50 billion deep links into apps. This is also an excellent vehicle for app discovery, helping users find apps with content related to their interests and helping app publishers reach new users. The “Buy Button” rumored for Google Shopping could easily find itself an excellent tool in App install ads in the future.

Google Now. Google Now is well familiar to Android users. Based on your searches, your calendar, your email, your location, and other personal information available to Google on a historical and current basis, Now automatically suggests content, reminds you of appointments and events of interests, checks your commute, delivers news alerts, and other contextually appropriate information. This always on assistant has become very popular with consumers, allowing them to bypass search and other apps to get information that they want and presenting information consistent with their interests for which they may not have otherwise thought to search. While co-opting valuable discovery from the apps, it is also a vehicle for presenting deep links into apps and for app discovery.

Now on Tap. Just announced at I/O, Now on Tap adds a search tool available to Android users while they are already engaged with another app. By tapping and holding the home button while in an app, Now on Tap will search based on the context of the app and respond to queries spoken or typed. For example, accessing Now on Tap while reading an email would automatically bring up information about the restaurant mentioned in the text. Interestingly, an Android user could use Now on Tap to bring up price comparisons for a product found on Amazon, or alternative hotel deals from the middle of Priceline. We believe that this is a powerful weapon in defending Google’s primacy in mobile.

Having introduced App Indexing, Now and Now on Tap just in the last two years, it is more than likely that Google will have further innovations to protect and extend its Search hegemony in the future. At some point, that bearish narrative for mobile search will have to change.

Fragmentation

Google’s strategy to drive global smartphone penetration by offering free, OEM-friendly Android licensing terms to hundreds of electronics manufacturers worldwide has worked almost too well. Yes, Android is the world’s dominant mobile platform, with some 1.5B devices in operation, but those have a wide variety of sizes, specs, and software vintages. OpenSignal measured 18,796 distinct Android devices last year (Exhibit 25). The top 10 most popular Android devices make up 15% of the installed base. Apple on the other hand cranks out a new version or two of the iPhone every year, for a total of 10 distinct iPhone models released since 2007 (excluding carrier, memory, and color options). Unlike Apple’s iOS, which boasts over 82% of active iOS users are running the latest version, Android counts only 12.4% of its installed base running Lollipop which was released at roughly the same time. Another 39.2% of Android users run the 2013 KitKat version and 37.4% run the three-year old Jelly Bean (Exhibit 26).

Exh 25: Android Device Fragmentation, as of August 2014

Exh 26: Mobile OS Version Distribution by Platform, June 2015

The primary reason for this fragmentation is that device OEMs in the Android ecosystem are responsible for managing the roll out of new OS updates to their end customers. Many of these OEMs have written their own, proprietary skins for Android with various bells and whistles intended to differentiate their products from the many other Android devices with which they compete. Before these licensees can roll out an update, they must rewrite their skins to support the new OS release, port all of their proprietary apps and then port the proprietary apps that many carriers around the world add. This takes time. Thus, the latest version of Android Lollipop (5.1.1) is available on new handsets like Samsung’s Galaxy S6, most Nexus devices, and a handful of Android One handsets, but has yet to be released for last year’s Samsung Galaxy S5 or for nearly every flagship phone from Motorola, HTC, and LG.

Moreover, by ceding responsibility for software updates to its OEMs, Google is also ceding quality control. . The OEMs have had a distinctly mixed track record. Samsung’s botched Lollipop upgrade of the Galaxy S5 featured bugs, battery drain, and crashes. While Samsung is making small incremental over the air updates available as it tackles the bugs, it has yet to release a stable version of Android 5.0.2 as of writing this note. In contrast, Apple, with total control over both hardware and software, and at most, a dozen active versions of its iPhone and iPad lines in use, can roll out updates all at once with relative confidence that unforeseen bugs are few.

Google has taken a few steps to battle the problem. At the low end of the market, the Android One program promotes a standardized, turn-key platform designed to be able to run the most recent version of Android right out of the box and to easily accept future upgrades to the operating system without additional tinkering. Thus far, Android One handsets have been successfully launched in seven countries, with plans for many more. At the higher tiers of the market, the problem is more difficult to solve, as OEMs see their software modifications as important market differentiators. Here Google is being proactive, negotiating with the biggest OEMs to tone down their skins in an effort to make the upgrade process work more smoothly, to the benefit of users. The success or failure of these friendly negotiations is uncertain.

The other downside to fragmentation is that some more aggressive OEMs have begun to strip away access to Google’s core services and replacing them with their own default apps. This trend weakens the value of Android to Google. To combat this, Google has two different types of licenses, one for OEMs that use the kernel of Android to create their own, distinct fork that does not use any of Google’s core services – e.g. Amazon’s Fire – and another for OEMs that do not wish to forego Google services. Google will no longer allow its licensees to pick and choose which apps they want to support, they must agree to preinstall as many as 20 apps that have been designated as mandatory, to place certain key apps in prominent positions on the home screens, and feature Google Search with a box at the top of each screen. As licenses expire, Google’s insistence on these terms in renegotiations should reign in this trend.

Exh 27: Google and the Global Advertising Market, 2014

Government Intervention

The dominance of Google’s search, digital advertising, and Android franchises has drawn the attention of regulators over the years. Google Search has about two thirds share in the US, well over 90% in most European markets, and roughly 80% globally. Worldwide, it collects about 55% of all search ad spending, 32% of total digital advertising spending, and 50% of mobile advertising spending (Exhibit 27). Android is the dominant mobile platform, running some 75% of the installed base of smartphones worldwide and more than 80% in most of Europe. Taken together, the desktop Chrome and mobile Android browsers have about 49% of the European browser market. Market shares like these are Microsoft-esque in the eyes of regulators.

Exh 28: 2014 Top US Federal Lobbying Spenders – All Industries

The US. Predictably, Google has faced investigations on both sides of the Atlantic. Earlier this decade, the US FTC launched an inquiry centered on how the company’s patent practices could stifle competition for devices as well as search. After Google’s acquisition of Motorola Mobility in 2012, it was alleged that Google reneged on its FRAND license commitments and pursued or threatened to pursue injunctions against companies that needed to use the Motorola standard essential patents and were willing to license them on FRAND terms. The FTC’s internal staff report on this investigation was leaked earlier this year and revealed staff recommendations to the commissioners calling for a lawsuit challenging Google’s business practices. During the investigation, the FTC was also weighing a competing report from the agency’s economic bureau that didn’t favor legal action. Ultimately, the FTC’s case ended in January 2013 when Google agreed to a consent order that would prohibit it from seeking injunctions against willing licensees in federal courts or at the International Trade Commission (ITC). The company also made further agreements to remove restrictions on its ad platform that would have made it difficult for advertisers to run campaigns across multiple platforms.

Google remains one of the most active tech firms lobbying in Washington, looking to educate lawmakers on the unusual nature of Internet competition and to rally support for its domestic and international activities. The company ranked 9th in total lobbying spend last year behind the US Chamber of Commerce, the National Association of Realtors, and Comcast which was busy trying to get its acquisition of TWC approved (Exhibit 28). Year to date, Google has climbed to fifth place in lobbying spend, and is the only non-cable/telecom and non-mil/aero tech company to crack the list. News reports suggest that Google and its lobbyists have averaged nearly one meeting per week with Executive Branch personnel in the White House. Google’s support was likely instrumental in driving the FCC to implement strong Net Neutrality regulations, evidence of its growing clout.

Europe. Google has faced scrutiny in Europe on a number of fronts including taxation, EU specific laws, and antitrust. Google is accused of avoiding taxes in Europe with the structure of its Ireland and Bermuda subsidiaries, an approach also used by several of its industry rivals. Irish tax law doesn’t include US transfer pricing rules and the country only levies tax on revenue earned on Irish soil. Combined, these characteristics set up a loophole called the “Double Irish” scheme. Essentially, an advertiser can buy an ad in the UK, Google then sends its month to an Irish subsidiary which holds IPR. While the corporate tax rate is 12.5% in Ireland, the Irish subsidiary can pay a royalty to another offshore, but EU company, and get a deduction. The money then roundtrips back to Ireland with no withholding tax given the transaction was made in the EU. The other Irish subsidiary pays no tax since it is controlled outside of Ireland, most often out of Bermuda or another tax haven. The Irish government banned the practice as of January 2015 and some companies currently engaged in the practice have until 2020 to wind down use of the loophole. With the crackdown, Google’s effective EMEA tax rate will go up.

Differing views on privacy and freedom of speech have also impacted Google’s business practices on the continent. A May 2014 ruling by the European Court of Justice over a human rights concept, “the right to be forgotten,” that has been accepted and made law in Europe has effectively forced Google to censor search results based on reasonable user requests. The “right to be forgotten” is an extension of the right to privacy that could give one the right to silence a past event that is no longer occurring. For example, someone that was convicted of a crime, but served their sentence, could request that Google or any other search engine operating in the EU take down search results that would display potentially disparaging information. Essentially, Google or other search providers do not destroy the primary sources of information, they just make it more difficult to find. The ruling doesn’t fundamentally change the algorithm, but creates an additional compliance burden for Google.

Google may have thought that it had sidestepped a European Union antitrust investigation when it agreed to a settlement in early 2014 requiring it to give rival e-shopping firms more prominence in search results. This agreement would have allowed the company to keep its search algorithm as is, and to avoid fines that theoretically could have reached into the mid-single-digit billions of Euros. Despite the agreement, the political hounds continued to bark – the European Parliament, which has no power over antitrust issues, passed a resolution in November 2014 calling for tougher regulation of search and unbundling search from advertising and other services. To observers that understood that the only way that search can be provided for free to consumers is to bundle it with advertising and other services, the empty resolution was almost comical.

Then in April 2015, the European Commission under new competition chief Margrethe Vestager, sent a formal “Statement of Objections” to Google alleging the company has been abusing its dominant position in the general search market by systematically favoring its own comparison shopping product in search results. Separately, the EC has also opened an investigation into Android and unfair app bundling. The Android investigation will focus on three areas: whether Google has hindered the development and market access of rival apps, whether Google has prevented device makers from installing their own modified versions of Android, and whether Google is bundling its apps and services on Android devices with other Google apps and services (Exhibit 29).

Exh 29: Smartphone OS Market Share in Major European Economies

The outcome of these investigations will not be clear for many months, and there may be considerable speculation about the dramatic remedies for which the EU may ask – a corporate break-up and/or billions of Euros in fines are the most lurid potential headlines. Despite the hyperbole from Ms. Vestager, we believe the most disruptive outcomes are highly unlikely. First, the most painful remedies would draw strong condemnation from the U.S. Government, as the reopening of the investigation of Google is widely viewed as a political and protectionist move. Second, a move to break up or significantly weaken Google would likely hurt European consumers, who are avid users of its services. Google could decide to withdraw certain services from the EU rather than comply with any overly harsh remedy. Third, there is no obvious harm to European consumers, who voluntarily access Google’s services for free, and harm to European would-be competitors is dubious, given the overarching threat of the internet to the publishers and merchants pushing the investigations irrespective of Google’s role. Fourth, it is entirely impractical to separate Google’s free search and Android businesses from its moneymaking advertising business or its infrastructure, and we expect that cooler heads within the EU will eventually figure that out.

More likely, the EU will look to institute a fine, which by European law could rise to as much as 10% of annual revenue, or roughly 6 billion Euro. Even here, the EU would have to prove that Google intended to stifle competition and harm consumers, a difficult task in a market where the products are free and competition to the current status quo can be seen in many directions. The EU may also require Google to change some business practices to a greater extent than was agreed to in the 2014 settlement. We expect that this renewed investigation will also be resolved via negotiations, likely with a fine well below the limit and additional changes to Google Shopping and restrictions to the services that can be made mandatory for Android licensees. We do not expect these remedies to greatly affect the company’s long term business strategies or to impose a significant cost to Google shareholders.

Competition

While the EU accuses Google of having vanquished its competition, investors know better. Google’s core businesses and new initiatives put it toe to toe with the most capable and accomplished players in all of technology. Google’s rivalry with Apple has been well documented by the media and demonstrated in court, with Apple’s device mastery grating against Google’s cloud superiority in the platform battle for the ages. Google’s m-commerce ambitions place it unambiguously against Amazon, while Amazon’s media moves edge it into some of Google’s traditional space. More than any competitor, Facebook wants to displace Google as the primary engine of discovery on the Internet – the two are the only companies on earth that can leverage more than 1 billion regular users. Even Microsoft comes into play, in part for its 3rd place mobile platform, but mostly for its role as the primary competitor for Google at Work. These are the four most valuable companies in tech, not counting Google itself, and each has an enterprise value in excess of $200B. Arguably, Apple, Amazon and Facebook would all list Google as their most important competitor. This is scary for investors (Exhibit 30).

Exh 30: Areas of Competition between Major Tech Platforms

Apple. The Apple-Google rivalry has the intensity of a partnership spurned. In the mobile first, cloud first era, Apple has been the face of mobile device innovation, introducing the iPhone in 2006 and with it ushering in a range of life changing technologies that are in the pockets and pocketbooks of nearly 2 billion people worldwide. The original iPhone launched with Google Search, Maps and Earth as key default applications, Google engineers were privy to the early workings of the iPhone, and Google CEO Eric Schmidt sat on Apple’s board of directors. However, secretly, Google was concerned, probably correctly, that Apple’s potential domination of a mobile future would put in position to eventually turn on its software partners and displace Google with apps of its own. To protect against that inevitability, Google bought Android and nurtured it into an open source alternative smartphone OS, one that OEMs could use to combat the iPhone with an Android Army of me too devices that tested the boundaries of patent and trade dress protection.

According to biographer Walter Isaacson, Steve Jobs said of Android “I am going to destroy Android, because it’s a stolen product. I am willing to go thermonuclear war on this. I will spend my last dying breath if I need to. I am willing to spend every penny of Apple’s $40B in the bank to right this wrong.” Apple obviously hasn’t succeeded in its founder’s quest, but it is definitely still trying.

Share shifts in the Android-iPhone war no longer have much real significance for Google’s future success. Apple has resolutely insisted on focusing on the high end consumer with the wherewithal to buy a $700 smartphone. This has left the rest of the market open, and Google’s OEM partners have aggressively driven prices (and margins) down in desperate lunges for market share. More than 75% of the world’s smartphones are now powered by Android. Meanwhile, Google remains the default search provider for Apple, and has a strong slate of popular apps in the iTunes App Store. Given the upscale skew of the iPhone user base, many surmise that Google makes more mobile advertising on iOS than it does on Android despite the more than 3-1 user base advantage, although we note that Google pays Apple a multibillion dollar fee for its default position in search and a 30% bounty off of the top of advertising it sells for its other apps.

The real threat is that Apple will displace Google’s apps with apps of its own, cutting it off from that ad revenue. This is unlikely for the foreseeable future for a few reasons. First, Google’s apps are truly outstanding, with considerable equity built up with Apple’s on users. Innovations, like Google Now and Photos, also show that it is not resting on its laurels. Second, Apple has a terrible track record at developing and delivering cloud applications. The Apple philosophy is that the device itself should be the nexus of computing and storage, a religion that kept the company from meaningful participation in cloud applications until the last few years. Apple’s cloud-based products have been its biggest disappointments – Siri, iCloud, and Maps to name a few. Apple’s data center infrastructure is generations behind and magnitudes smaller than Google’s. Apple blasé attitude toward the cloud has left it bereft of data center and cloud application talent – the cool people at Apple are in Jony Ive’s design group, not at the data centers. Third, if Apple can’t do it itself, it has few good 3rd party options – Microsoft is the only reasonable alternative for search and there is no love lost in Cupertino for the good folks from Seattle.

Amazon. Google Chairman Schmidt tags Amazon as the company’s most potent competitor. Its vast and efficient e-tail operations, including the marketplace it provides for tens of thousands of 3rd party merchants, is the primary obstacle for Google’s m-commerce aspirations. Amazon is courting the loyalty of its customers through its Prime program, giving them substantial incentives to begin and end their shopping experience with the Amazon App. Google is looking to counter that with a streamlined shopping experience via Search, superior support for “omni-channel” shopping, the Now on Tap information overlay available to users already in the Amazon App, and deep support for 3rd party merchants and their loyalty programs. Both companies are rolling out same-day delivery services, with Google’s investments in autonomous vehicles matched by Amazon’s initiatives in delivery drones. Ultimately, we believe that the m-commerce opportunity is far, far too big for a single company to dominate and that both Amazon and Google are likely to be very successful in navigating the rapidly evolving state of retail.

Amazon is also Google’s top competitor for enterprise IaaS hosting, an industry opportunity that we believe will be well into the $100’s of billions by the end of the decade. We believe that Amazon and Google, along with Microsoft, will dominate this market, based on their considerable advantages in data center infrastructure over the other market hopefuls. Of the three, Google has the lowest cost and highest performance, perhaps by a significant margin, but it has not committed itself to the market as fully.

Facebook. Unlike Eric Schmidt, investors believe that Facebook, the self -proclaimed “on ramp to the internet” is Google’s biggest rival. Facebook reaches more than 1.4B users on a monthly basis, nearly half of the humans on earth that have access to the Internet, and accounts for about 6% of the total time spent on line in the US. Google is the only other company that can be mentioned in the same breath. While Google still leads comfortably in online ad revenues with 40% of total industry sales and 50% of mobile ads, Facebook is growing at more than double Google’s pace, and has executed its mobile strategy with precision. Investors fear that Facebook will find a way to displace Google as the primary tool for discovery on the mobile internet, and in the process, overtake it as the leader in digital advertising.

Like Apple and Amazon, Facebook is certainly formidable, but Google still holds a trump card in Android, the platform of choice for more than a billion smartphone users. A large majority of Facebook’s users access it via Android, and it is clearly vulnerable to Now on Tap and any other future platform overlays Google may place atop Android apps. It is not at all clear how Facebook can really compete on m-commerce specifically or product discovery in general. The biggest threat that Facebook poses to Google is in user generated video, once the sole province of YouTube. Here, we expect real impact – Facebook is already drawing video views away from YouTube and may force Google to sweeten its advertising splits for its contributors. Still, the enormous archive of content, established audiences for exclusive programming, and track record of innovation should leave Google in the lead long into the future, with overall market growth in streaming video more than enough to accommodate two successful franchises in the ad supported, 3rd party short-form segment.

Microsoft. Google’s rivalry with Microsoft is more oblique than the other top internet players, but no less intense. This intensity is readily apparent in the barely concealed rancor of Microsoft’s “Scroogled” advertising campaigns against Google’s Search, Shopping, Chrome, Gmail and Android franchises. These ads, intended to support Microsoft’s own Bing, Internet Explorer, Outlook and Windows products, had the tone of political attack ads and proved to be unsuccessful over the two years that they ran. Amongst consumers, Microsoft is a David amongst Goliaths – its internet explorer and outlook franchises are being swamped by shift in mobile, where Windows is a distant third with just 3% global market share.

The story is completely different in the enterprise. There, Google at Work’s email and office suite products are overwhelmed by the dominant Microsoft Office and Outlook, both having successfully transitioned to a SaaS subscription program while maintaining backward compatibility with millions of customers and billions of documents relying on it. Microsoft Azure will be a strong competitor for IaaS hosting, made stronger by the SaaS applications and infrastructure tools that are being integrated with it. Microsoft has a thick web of relationships across the enterprise IT market and a deep understanding of the computing needs of business customers. This will be difficult for Google, and for that matter, Amazon, to compete with.

Still, Google has some excellent cards to play. Its data center operations are significantly lower cost, enabling Google to be aggressive on pricing for IaaS. It is more flexible in job scheduling than its rivals, allowing it to offer capacity on demand in increments of varying sizes far more easily. Its analytical tools are the most powerful in the industry. We believe that Google should partner with a traditional IT company, like Cisco, EMC or HP. Such a partner could bring sales relationships, an understanding of customer needs, and complementary technologies to bundle with Google’s considerable cloud capabilities.

Valuation

What’s it Worth to You?

We believe Google’s towering leadership in data processing technology development and deployed infrastructure is the most valuable asset for the long term future possessed by any company in TMT. It is more valuable that Apple’s mastery of device design and tightly controlled, deep pocketed customer base. It is more valuable than Amazon’s clearly superior online shopping, warehousing and delivery operations. It is more valuable than Facebook’s social graph with detailed information about its 1.4B monthly users. It is more valuable than Microsoft’s office and windows franchises, and its connections to the millions of organizations that rely on them.

Yet Google’s current valuation is a considerable vote of no confidence by investors. We consider valuation using a two stage framework that separates enterprise value (EV) into two parts. The first, short term value, is set by the free cash flow growth assumed by consensus projections. The second, long term value, is set by the 5th year terminal value, implied by subtracting the present value of 5 years of free cash flow, as a percentage of EV. In our framework, Google is a charter member of the Skepticism Quadrant, a group of stocks with better than median anticipated near term FCF growth, and worse than average implied terminal values as a percentage of EV (Exhibit 31). In fact, Google rates worse on this metric than 80% of the 188 large cap stocks that we track, behind such questionable long term Internet bets as AOL, Expedia, Yelp, Pandora, and Ebay, and poorly positioned enterprise players like Oracle, HP, CSC and Accenture.

Exh 31: SSR’s TMT Valuation Framework CHART – “Skepticism Stocks”

Google looks pretty cheap on traditional metrics as well, trading at 16.3x forward earnings and 5.3x trailing sales, with a 1.24 PEG ratio, all against a 20% projected free cash flow CAGR. These multiples sit way below companies with far less going for them. For a company with unchallenged leadership in cloud-based data processing positioned against multi-trillion dollar opportunities in mobile commerce, media, IoT, and enterprise, the market’s perspective is far, far too pessimistic.

Exh 32: Time Spent in Media versus Advertising Spend in the US, 2014

Global digital advertising is projected to grow at just over 12% per year over the next few years, according to a PWC study. This perspective is echoed by several other researchers, all of whom rely on historical trend analyses to reach their conclusions. We believe this is a reasonable baseline, but that the future reality is more likely to skew to the upside than downside, as the percentage of ad sales captured by digital moves to catch up with the much higher percentage of consumer time spent online. (Exhibit 32). Consensus for Google’s revenue growth over the next five years more or less tracks these baseline expectations for digital ad growth.

We see real upside. Google’s m-commerce and digital media initiatives position it to gain additional digital advertising share as the balance of traffic continues to tip to mobile. Note that the company’s share of mobile ad spending, just under 50% is more than 1000 basis points above its overall digital ad share, and that Google’s control of Android puts it in an advantaged position to maintain its trajectory. Google also has considerable opportunities to grow its non-advertising revenues, currently just 10% of total sales and growing 35% YoY, considerably faster than its traditional businesses. Businesses like Play Store content and Google Compute Engine IaaS, products like Chromebooks, Chromecast, Nexus and Nest, and services like Fiber and Fi, all reside in this omnibus category. New opportunities created by moonshots, acquisitions, and under the rader investments, like Cardboard, will also show up here. Within the five arenas that we examined – m-commerce, digital media, devices/IoT, the next four billion and enterprise – Google is addressing trillions of dollars in markets, without considering the future markets for which it may be qualified by its information processing prowess – e.g. transportation, health care, robotics, personal finance, etc.

A simple topline revenue model growing Google’s ad revenues in line with the digital advertising market and growing the “other category” by about 30% on an annual compounded basis, would grow non-ad revenue to nearly 18.5% of total revenue and yield accelerating overall growth at a more than 14% CAGR (Exhibit 33). For a company that has so many non-ad products in development, this is rather conservative. A company with this profile will deserve a premium to the market rather than a sharp discount. All management needs to do is change the narrative.

Exh 33: Simple GOOGL Topline Model, 2014-19

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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