I’ve been interested in Alphabet for a long while as a potential investment. The business has a number of the most used products in the world, a very wide and deep moat, and earns very strong returns on its invested capital. The hard part for me is getting over the hurdle of paying a high multiple of current earnings for the business.
Alphabet’s products have inherent network effects that have resulted in its current economic moat. It all started with the high-quality search results that Google’s search engine provides. The best search results attracted users. The increase in users brought the advertising dollars. The advertising dollars were used to improve the search engine and the improvements brought more users. That has been Alphabet’s business model with almost all of its products: make an awesome product, make it free, advertise, and improve.
I intend to write a series of posts about Alphabet to provide some clarity to my thoughts about the company. This first post is going to cover advertising, Alphabet’s primary business. Future posts will cover risks and other parts of the business, including Google Cloud Platform, the Other Bets segment, capital allocation, etc.
Alphabet’s advertising business, which falls under the Google segment, brought in 86% of the company’s revenues in 2017, a smaller share than in the past because the company has started earning significant revenues from other businesses. It’s almost a guarantee that advertising will become a smaller part of the overall business over time, but it will always be a significant portion of total revenue. Alphabet provides advertising on its own properties, such as its search engine, Maps, Play and YouTube, as well as advertising on other websites that it calls its “Network Members”. In 2017, 82% of advertising revenue came from advertisements on Google properties, which has steadily increased from 71% in 2012.
Alphabet’s ability to create or acquire great products and offer them for free has led to a significant share of the overall global advertising market. According to Statista, 18% of all global ad dollars and 44% of all digital advertising dollars were spent on Google’s advertising platform in 2017.
Digital advertising across the globe grew at an astounding 21% in 2017 to around $217 million according to eMarketer. Growth in digital advertising is expected to continue at high rates as it takes market share from other offline advertising mediums. I would expect that Google grows at a similar rate to the entire digital advertising market going forward based on the value proposition it offers advertisers. That begs the question: what makes Google’s advertising better than others?
The simple answer is that Google has a lot of eyeballs looking at its products and Google has a pretty good idea of what those eyeballs want to see. If you look at the chart below, it gives you an idea of the breadth of Alphabet’s products and the extraordinary number of users for each (the data comes from early 2017).
It has eight applications that have over 500 million users, with six of these applications boasting over one billion users. In the advertising world, eyeballs matter and Google has them. The interesting thing is, Google doesn’t charge its advertisers just for users looking at the advertisements. The advertiser gets charged only after a user has decided to actively engage with the advertisement by clicking on it. What if advertisers were charged by a billboard owner only after a driver called the number posted on the billboard?
Advertisements on YouTube are slightly different. Users typically have the option to skip ads at the beginning of videos after five seconds. If the user skips the ad, the advertiser is not charged. In contrast to the other types of advertisements Google offers, the active choice is to skip the ad, not click on it and engage with it.
The second part of what makes Google so good at advertising is that it knows a lot about its users and knows what they want to see. On Google’s search engine, advertisers buy advertisements based on key words in a search query. If someone is looking for a tax attorney in Spokane, WA, tax attorneys can bid for those key words and get advertising space on Google. Google makes the decision on when to place the ad in front of a user based on the budget of the advertiser and the relevance of the ad to the user.
Google also has a number of ways to collect data on its users and target advertisements to them. Google collects data while you navigate the web in Chrome and probably already knows that I’m writing this post. That data allows it to place advertisements on its own websites and Network Member websites that you visit. If you use Google Maps, especially on your phone, Google knows where you are, giving them the ability to target local advertisements to you. The Google Marketing Live keynote from July 2018 gives you an idea of the power of Google’s advertising business.
So the bottom line is, Google is really good at putting advertisements in front of the eyeballs that want to see them and it has a ton of eyeballs to show them to. This ends up driving a much higher return on investment (ROI) for every advertising dollar spent, and is a driving factor in the shift from offline to online advertising.
The chart below – although admittedly a bit outdated (it’s from 2009) – shows the estimated return on investment for various advertising mediums. I would guess that online advertisement ROIs have improved since then, considering the ability to target ads has improved, especially with the ubiquity of smart phones and knowing where people are when advertisements are placed.
You can see that TV advertising has a similar ROI to online advertisements, but there is a significant difference between the two in terms of total cost. TV advertising is prohibitively expensive for smaller businesses, while online advertising is cheap.
I read an article the other day that discussed the impacts that cheaper online advertising has had on large consumer goods companies. Advertising and distribution was a barrier to entry in consumer goods for a long time, giving the larger companies like Proctor and Gamble a distinct competitive advantage. However, the low cost of advertising and distribution made possible by the internet has severely eroded that moat. Google and other digital advertisers, such as Facebook, offer significantly better advertising options for small businesses than those previously available, another important factor in the market shift from offline to online advertising.
In summary, Alphabet’s advertising business has a very large, durable economic moat created by the network effects inherent in its business model. Digital advertising should continue to take market share from offline advertising, and I expect Google to roughly maintain its dominant share of the digital advertising market. This leaves Alphabet with the opportunity for significant growth in the foreseeable future in its main business.
Stay tuned for the next segment of my Alphabet analysis, discussing other nascent portions of the company that have great potential to drive additional growth as well as discussing the risks to investing in Alphabet.
Brian Binder is the portfolio manager for Stonebridge Value Capital, LLC, an investment management firm that focuses on investing in high-quality businesses for the long term.
Myself and my clients currently have no investments in Alphabet, which may change without prior notice. This post should not be considered investment advise nor a recommendation to buy or sell a security. It’s imperative that each individual do their own research.
If you’re interested in discussing Stonebridge Value Capital, LLC managing a portion of your capital, please contact me at firstname.lastname@example.org.