DETTA INLÄGG ÄR ETT UTDRAG UR HALVÅRSBREVET JAG SKICKADE TILL PANDIUMS ANDELSÄGARE 5 FEBRUARI 2017.
Investing in Alphabet
Although I've always been aware of Google's strong business I've never really taken a closer look. I've kind of assumed that it is unlikely to be undervalued given its strong performance, size and fame. But, a friend of mine recently started an online business selling a high price, standardized service with no repeat business. During our discussions about running it, I got a different understanding of Google and its moat. My "insights" are probably known truths in the VC/tech industry, but I've not seen any research on Google in the public equity markets that takes this approach.
Google is in the (online) real estate business
Most sell-side analysts look at Google's future growth potential based on how much of the global advertising market they can take. Since Google already has around 15% of the total global market and around 45% of the online advertising market the future potential seem limited. But, I think that's an incomplete picture. What Google does for businesses, as a key gateway to the internet, is to replace physical real estate as a mean to connect with customers. Advertising is one part of it, but not all. The reason is the power of competitive forces. As businesses move online there are large cost savings compared to doing business offline, e.g. rent. But, just as lower fuel prices have limited long-term effect on airline profitability, the cost savings of the internet will not benefit businesses in industries with low barriers to entry. Instead competition will make sure all savings are spent on increased value for the consumer and on expenses related to connecting with the customer (now that the businesses do not have a physical presence).
A (very simplified) example: Pretend you start an online business selling cameras. By being based online you save 20% on costs compared to your competitor that has a store on a busy shopping street. You lower prices by 5% and hope that customers will buy from you instead. But since the internet is big, they do not even find you. So, you spend another 2% on Google AdWords and sales take off. Soon your success attracts attention and since there are no barriers to entry, a couple of other entrepreneurs set up online camera stores. To get closer to the customer they start bidding up the price for the adwords. Your sales decline so you lower prices and increase your adword budget a couple of percent. The competitors soon do the same. You get the point. In the end, competition will force the online camera stores to spend the 20% cost savings on online advertising and higher value to the customer because at that level they make just enough profit to justify staying open.
To conclude, I think the online advertising market is not only taking a piece of offline advertising but from all other cost savings related to moving from an offline to an online world. That does not only include the obvious ones like rent but also others like information asymmetry and search cost. It is big. Google is therefore not only in the advertising business, but also in the real estate business. Being the main method for searching the content of the internet they have a prime location. With this as a framework and considering that we are still early in the offline to online transition I think that Google has a longer runway for growth than most seem to assume.
Will Google keep its prime real estate?
So, Google's moat is that is one of the key connection points to the internet for consumers. They have an 80% market share of global search today and using Google is well ingrained in people’s behaviour. They have reached this position by offering the most accurate and fastest search results. Going forward, by having the most queries and user data their search results become increasingly more accurate which further strengthens their moat. Being the biggest also makes them the most attractive platform for businesses to advertise on.
Is Google’s moat impenetrable? No, none are. In time the marginal benefit of all the search data is likely going to decrease and the search quality difference between Google and its competitors will decline. Maybe, that has even happened. Also, given the low switching cost people’s behaviour could change due to external events or smart competitors. That said, even a giant like Microsoft/Bing has been slow to make a dent in Google’s search business. Another thing that will likely happen is that Bing and others will reach critical scale and justify them as advertising channels. And since you can get better returns on your advertising dollars there today (since the cost-per-click is usually lower) it is a threat. That said, I think all these changes will happen slowly given Google’s strong position today.
Another threat is the creation of other prime real estate. A good example would be Amazon. If you want to buy a product in the US today, you are probably more likely to go straight to Amazon instead of through Google. Amazon has a better platform for making informed product purchases through its wast selection and review data base. Another example would be popular apps. If consumers start to access the internet mainly through apps it would diminish Google's value proposition to advertisers. So far, that problem has mainly been related to platforms that are already stand alone prime real estate (like Amazon).
My view is that the consumer can keep a limited number of choices/connection points/sellers in the top of their mind. Google is likely to be among those since the search function is critical to accessing the internet.
Potential outside of search
Besides Search, there are other businesses that will contribute to the growth going forward, YouTube and Cloud being the most mature today.
YouTube has over a billion users. Today the service already reaches more 18-49 year olds than any cable network in the US. In 2015 users where spending on average 40 minutes per session. Online video advertising is expected to double over the next 3 years and given YouTube’s strong position I am optimistic about its prospects. Unlike the Search business YouTube takes a piece of the "regular" video advertising budget. But it adds value by being much more exact. When video advertisers can target customers based on location, behaviour and other factors, it creates new possibilities. I have for example seen video ads for a local bicycle shop. Since I did not know about the shop and was just looking for a helmet to my daughter, it was well spent money by them.
Google is currently the third biggest provider of public cloud computing services (behind Amazon and Microsoft). The industry growth is tremendous, last year the top three players grew well above 50% in total. It is too early to tell exactly how it will play out, but I think there is a good chance cloud computing will become a meaningful business for Google.
Google is known for making many different so called “Other Bets”. They are high risk-high potential projects within different industries. It includes e.g. Nest, a producer of smart home devices, and Waymo, an autonomous car developer. The Other Bets are still small and I have not assumed any value or growth from this segment.
Management is great and financial discipline and transparency has been introduced
The main goal of management should be to protect and widen the moat. From that standpoint the leadership team of Google has been excellent. There have been at least two consumer behavior changes that could have displaced Google: mobile and video. But management saw them coming and proactively acquired and developed both Android and YouTube. Both are today dominant in their respective market and critical components of Google’s moat.
Google’s management have been criticized for how frivolously they spend money on ideas outside of the core business and the lack of transparency. Both issues were dealt with through the hiring of Ruth Porat as CFO in May 2015. She was previously CFO of Morgan Stanley and was recruited to provide “adult supervision”. She has already made an impact. Google now reports its moon shots projects separately from Search and evaluate and manage them closer from a financial perspective. They have also started to return cash to shareholders through buybacks, which is good.
Valuation is attractive
Google is being valued at ~18 times my estimate of next years earnings (on the core business, adjusted for cash), which I think is too cheap for a company I expect to produce double digit growth for many years to come. The S&P 500, which has weaker fundamentals on every key metric, is trading at a 17.5x forward multiple. I think that the investment will produce a satisfactory return with limited downside.
Why do I exclude Other Bets, especially since they are losing $3.6 billion? Because, it is discretionary growth capex. Now, that financial discipline has been introduced I expect management to review the projects from a return perspective and close the unpromising ones. Over time, the value should be above zero.