Alphabet is now the parent and holding company of tech giant Google, following a restructuring of the Google business in recent years. An international business with a reputation for market dominance, Google’s European operations are headquartered in Dublin. The question regularly arises as to whether Google, the consumer-facing brand, holds too much power. No matter which side of the fence you sit, the company’s financial performance is strong.
In a July press release on Q2 financial results, the Google CEO is quoted as saying “our effort to build a more helpful Google for everyone brings countless opportunities to help users, partners, and enterprise customers every day”. The business is continuously investing in new technologies, and in engineering talent, to further build on its connection to the consumer. It is constantly pushing the boundaries of the internet age. As a result of its phenomenal success and integration into so many aspects of our daily life, it is increasingly becoming the source of government oversight, which will likely be management’s next hurdle. Its core business is an advertising model built around technology tools which have become almost indispensable in modern life.
Advertising reflects c. 84% of group revenues. Alphabet’s advertising business leverages a range of online and mobile applications, referred to as “Google Properties” which include familiar products and services such as search, Gmail, Google Maps, Google Play and YouTube. The remaining 16% of revenues are generated from Google’s other businesses. These include Android’s (smartphone operating platform) Apps and Digital Content, Cloud, Hardware and YouTube subscriptions, the more experimental division of the business known as “other bets” focused on research and development of autonomous cars, robotics and artificial intelligence, and investment vehicles (Google Ventures and Google Capital).
Google continues to impress investors as it grows its top line by c. 20% with its core advertising model performing strongly. Revenue growth had been trending lower from 2018 into 2019, having fallen from highs of 26% year-on-year in Q1 18 to 17% in Q1 19, causing investors to question whether the model remained attractive. Growth rates recovered back to long-term averages in Q2 at 19%, broadly in line with its 5-year average growth rate of 19.5%. Traffic acquisition costs (TAC) are the fees Google pays to other platform operators to run Google search as a default search option, namely Apple. Increasing TAC costs were another source of concern in 2018, which have again begun to show signs of stabilising at c. 22% of advertising revenues. Not only is Google a high growth business, it is also a highly profitable business. The business generates an operating margin of 20%, which can vary each year depending on the business’s investment cycle. Capital expenditure is generally recognised in the income statement, with the current year’s R&D spend running at €12.2bn or 16.2% of revenues (compared to 15.6% for FY18). The balance sheet is exceptionally strong with extremely high cash levels, minimal debt and high shareholder equity.
Some of the primary risks associated with Google are antitrust investigations and patent and intellectual property rights. Antitrust violations relate to the infringements on competition law. The European Commission has fined Google on three occasions, for various infringements of EU competition law. All three fines are subject to appeals and amount to €8.2bn ($9.5bn). The first case relating to the display and ranking of shopping search results and ads in 2015 saw a fine of €2.4bn imposed. The second, relates to provisions in Google’s Android-related distribution agreements, amounted to €4.3bn in 2016. The final decision relates to contractual provisions in agreements that Google had with AdSense for Search (AFS) partners, which amounted to €1.5bn in 2016. Competition authorities in Brazil, Argentina, India and Korea have investigations ongoing. The biggest risk on the antitrust front is whether or not the US begins investigating similar matters. The size and volume of personal data that Alphabet and other large technology companies hold on consumers have been subject to political debate for some time. Democratic candidate Elizabeth Warren could be a disruptive force in the continued growth of these stocks by seeking to break up the business into smaller components or enforcing new regulations resulting in increased operating expenses. Alphabet is the subject of several patent and intellectual property rights lawsuits, which could result in substantial monetary damages, costly royalty or licensing agreements, or orders preventing certain features, functionalities, products, or services.
Valuations remain the key measure of how investors assess if a company is expensive or cheap. Many people may expect Alphabet to be expensive in line with some other recognisable technology disruptors such as Amazon, Uber or Netflix, but surprisingly Alphabet trades at a c. 20% premium to the broader S&P 500. In our opinion, this premium is justified when you compare both revenue and earnings growth rates to the broader market and the quality of Alphabet’s earnings.
Considering Alphabet’s investment thesis, we continue to see the core advertising business outperforming, delivering both growth and profitability. This growth should be supplemented as emerging products such as Cloud, YouTube subscriptions and Google Play develop. The business continues to invest in new technologies including Autonomous Vehicles, Internet of Things (IoT), robotics and Artificial Intelligence (AI) giving investors optionality on new technologies. Given the success and huge wealth Alphabet has generated it will however continue to be the subject of antitrust investigations and political interference, a topic which investors cannot ignore.
Pierce Byrne is Research Analyst with Cantor Fitzgerald Ireland.
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