Quick Thoughts: Things I Think About Google

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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April 27, 2018

Quick Thoughts: Things I Think About Google

  • The big sell off in GOOGL (and other big cap tech names) appears to be a reaction to rising CAPEX and OPEX outside of the core advertising driven franchises.
  • Digital ads are booming now and will benefit from an erosion in linear TV advertising, but long-term must slow toward the growth of the economy
  • GOOGL’s investments are in high likelihood, high potential opportunities, like Waymo and enterprise computing, that play to its considerable strengths
  • Investors have been willing to give AMZN room for its long-term investments. They should do the same for GOOGL

The market response to GOOGL’s 1Q18 results was a bit odd. At first, the stock traded up as much as 4% as investors reacted to a resounding revenue beat and strong, above consensus earnings. Ten minutes in, the enthusiasm waned, and the stock began to give back the early gains. Pundits live blogging the whole thing were uniformly perplexed – some marked it up to a percentage increase in traffic acquisition costs (TAC), others to higher than expected operating expenses, and still others to a big bump in capital spending. By the end of the conference call, the shares were down about 70bp and at the morning open, the rout began and not just in GOOGL shares. By the end of the day, GOOGL was down 4.5%, with its fellow FANGs AMZN, NFLX and FB each down more than 3.5%. Enterprise SaaS also took a big hit, with MSFT off 2.4% and rivals CRM, ADBE and WDAY even worse. What was so bad about GOOGL’s earnings that should have prompted this sell off? Some thoughts:

1. Digital advertising is still on fire. Alphabet’s advertising revenues were up nearly 20% YoY in 1Q18, even after TAC, to $20.3B net. At this run rate, the Google ad platform represents more than 13% of global “measured media” advertising (a metric which includes all the easily measured categories but excludes other major pools of marketing and promotional spending), making its growth even more remarkable. Google has been both a driver and beneficiary of the growth of digital advertising, which is now 41% of the total measured media pie, having already lain waste to newspaper, radio and print magazine ads. It has also bitten sizeable chunks out those promotional and marketing spending pools that are not included in the “measured media” ad market estimates. With $178B in global ad spending in 2017, TV is 35% of that “measured media” bucket and the obvious next, and possibly last, source of growth for digital. Given deteriorating audience metrics for linear television and the growing incidence of time-shifted viewing and 2nd screen multitasking that robs TV advertisers of the attention for which they paid, and we believe that the video advertising revolution is upon us, to the clear benefit of Google and its digital rivals and to the detriment of traditional media. We also note that Alphabet’s YouTube has an overwhelming lead in ad supported streaming video and stands to be the biggest beneficiary of this shift.

2. But, digital advertising is going to slow down someday. Numerous academic papers support the notion that advertising spending has been a stable percentage of GDP over many decades. Here is one https://sites.duke.edu/djepapers/files/2016/10/lightcap-peek-dje.pdf that makes the case that digital advertising should be deflationary for ad budgets over time, as the improved efficiency of targeted messages reduces the overall need to spend. We expect Google, Facebook, and a few lesser platforms will carry on coldly extracting revenues from traditional media operators and their deteriorating network audiences. Add in the global market, which tends to run a bit behind the US but is bigger, and we have sustenance for another 4, 5, 6 years of decent growth. But then what? Digital advertising sales will asymptotically approach a stable percentage of the overall economy (Exhibit 1). It will be hard to support a premium valuation on that. Alphabet and its rivals will have to look elsewhere for growth.

Exh 1: Global Digital Ad Spend Forecast, 2016 – 2022

3. Alphabet could have a $100B+ enterprise cloud business. A decade ago, analysts liked to say things like “Google isn’t a search company, its an advertising company”, boiling its business down to its primary monetization lever, but missing the company’s heart completely. Google was, and is, a computer engineering company, motivated by pushing science forward and finding ways to use its assets and expertise to deliver money-making products and services. Advertising was its first and still, its biggest source of revenues, but management has been looking for other opportunities all along.

One of these opportunities is as an enterprise cloud platform. Alphabet missed the boat on hosting at first, allowing Amazon a few years head start, but just like its Android smartphone platform ran down Apple’s iOS, Google Cloud Platform is looking to gain on the leader (and Microsoft, which is also ahead of it). The opportunity is huge. We believe cloud hosted computing, which addresses most of the nearly $4T in annual spending on private datacenters, will be a $450B global market in ten years. With few competitors, other than Amazon, Microsoft and, maybe, IBM, with the scale and wherewithal to play, the opportunity is extraordinary.

How can Alphabet win? First, it needs to stay ahead of its rivals with the cost and performance of its datacenters. It invented most of the tech underlying hyperscale architecture and it spends to both develop new generations and to deploy them (Exhibit 2). It derives scale not just from its commercial platform, but also from its massive internal computing resources. Second, it must differentiate its services up the software stack – not just computing and storage, but cutting-edge tools, APIs, and applications. It has the lead in key next generation technologies like AI and containerization. G Suite productivity applications are the only viable alternative to Microsoft Office and Google has powerful analytics tools as well, but there is room for a lot more here. A partnership with Salesforce is promising – Google Cloud Platform and Salesforce fill in a lot of blank spaces for each other – and we can easily imagine the alliance growing stronger. Finally, Google needs to win business a customer at a time. The Salesforce link-up will help a lot here, but investment in building out the sales organization is prudent. You don’t win deals like Snap, Netflix, Apple, AirBnB, and others without strong relationships.

Exh 2: Historical Capex Spending for Big Hyperscalers, 2012 – 2017

4. Waymo could also be a $100B+ business. We have written a lot about self-driving cars and Transportation-as-a-Service. You can read about it here (http://www.ssrllc.com/publication/self-driving-cars-waymo-and-gm-are-far-ahead-of-uberand-everyone-else/http://www.ssrllc.com/publication/googl-waymo-is-worth-75b-right-now/http://www.ssrllc.com/publication/autonomous-trucks-self-driving-convoys-are-years-away/http://www.ssrllc.com/publication/self-driving-cars-building-a-team-to-bring-taas-to-market/http://www.ssrllc.com/publication/autonomous-cars-self-driving-ambition/). Cutting to the chase, Waymo will launch completely autonomous commercial robotaxi service in Phoenix this year, two years or more ahead of all rivals. It is building an ecosystem (CARS, AN, Jaguar, etc.) and highly detailed 3D digital maps of new cities that will allow it to replicate its Phoenix operation from market to market to market. We believe that this market could be $100B in the US within 10 years, with further opportunity globally – all possibly dominated by Alphabet. This business would be worth $75B as an independent company today (Exhibit 3).

Exh 3: US Autonomous TaaS Market Forecast, 2018 – 2030

5. Alphabet is in a heated battle with Amazon for the “next” user interface. AI assistants have the potential to go far beyond voice commands for simple tasks (http://www.ssrllc.com/publication/ai-assistants-the-next-user-interface-paradigm/). We believe these assistants will become our primary connection to the resources of our devices and of the internet, obviating the need for individual apps. Voice will be an important input, but so will text, gestures, and context (e.g. location, time, user preferences, etc.). Many needs will be anticipated before a request is necessary. The assistant will follow the user, resident on their phones, their cars, their office computers and in their homes.

This is where Amazon got the jump on Google (and Apple) with the Echo, positioning Alexa as a primary connection for 30 million households worldwide. Google, which has the advantage of more than a billion Android users, is pushing hard to extend itself into the home as well. While the AI assistants may well co-exist with each other, we suspect that users will eventually migrate into distinct camps, with the preferred assistant having an inside track to directing users to goods and services. This is a powerful opportunity, an expensive one, and one that Alphabet should not cede to Amazon.

6. Alphabet’s technology strength and consumer reach enable other huge opportunities. Alphabet has acknowledged industry leading expertise in almost every aspect of computer science. Alphabet has assembled the deepest and most decorated roster of AI scientists in the industry, employing more than 25% of those that have been cited in academic publications at least 5,000 times and work for commercial enterprises. Reportedly, at least a quarter of its more than 40,000 engineers have been trained in programming AI models. Alphabet researchers are at the forefront of a wide range of hardware and software technologies behind larger scale, higher performance, lower cost and more ecologically friendly datacenters. It is one of a few companies making real progress toward quantum computing – Microsoft and IBM are its primary commercial rivals. It has strong competence in semiconductor design and an improving record in building consumer hardware.

Exh 4: Google’s AI Talent Roster is far Superior

Alphabet has also built seven different consumer franchises with reach to more than a billion regular users worldwide – Android, Search, YouTube, Chrome, Maps, Gmail, and Play, with Photos, Drive, Assistant, and a few others with the potential to join the club (Exhibit 4). While much is made of Facebook’s prodigious reach, with more than 2 billion MAUs, Alphabet’s reach is arguably just as broad (Android has more than 2 billion users and probably just as many are using Search). This is a huge asset – the reach of Android alone enables the reach of many of the other services and can facilitate the distribution of new products. For example: We expect Waymo to eschew distribution partners like Uber or Lyft for its autonomous robocab service because it can connect directly to its potential customers through Android, Maps, Assistant and other products. The same would be true for other products and services targeted at consumers.

Exh 5: Number of Monthly Active Users by Property

We believe that Alphabet’s combination of technology prowess and consumer reach is well ahead of other digital platforms and positions it for a wide variety of new possibilities. Consumer financial products – it is already involved via Google Pay, but surveys suggest that the Millennial generation would be very interested in a broad array of financial services (e.g. loans, demand accounts, insurance, etc.) from the Google if it were able to navigate the regulatory and other industry barriers that currently exist. Alphabet is working on a wide variety of health-care related projects from AI-infused medical devices, to research in Gerontology and population health management systems. Through its best-in-class power efficiency work for its datacenters, applying AI to manage electricity usage, Alphabet also has a foot in the door for future energy conservation opportunities.

7. Alphabet’s rising CAPEX and OPEX makes perfect sense. Alphabet could coast – focus on selling Search and YouTube ads, cut back on R&D and CAPEX, drop the Google X investments and all the hardware, shift Waymo to a tech licensing model, give up on competing with AWS, etc. – and short-term profitability would rise dramatically. Investors would probably cheer, but as the digital ad market matured and Google growth asymptotically approached economic growth their enthusiasm would wane. In contrast, we believe that the company’s vision and commitment to investment have set it up for its next narrative – one where robotaxi service and enterprise computing are the real growth drivers, with advertising as a cash cow and the next big opportunities a few years closer. For any investment horizon beyond the next few quarters, we believe Alphabet’s strategy is prudent.

8. Larry Page must envy Jeff Bezos. Amazon has been sacrificing its immediate profitability in favor of income statement investment in future business opportunities for many years – typically with Wall Street’s blessing. Tens of billions of dollars spent on streaming video content, device development, datacenter capital investment, expansion into international markets that might not pay off (e.g. China and India), drone delivery systems, and other initiatives could have been paid back to shareholders. Alphabet is asking for similar leeway, against a backdrop of considerably higher profit margins. We think the company has earned it.

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