We Don't Expect Alphabet's Recent Missteps Will Derail Its Long-Term Potential 

Director

Michael Hodel

Revenue segments as reported by the company.

Google Search & Other

YouTube Ads

Google Network Members' Properties

Google Cloud

Google Other

Other Bets

Hedging

Revenue Segments

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Gross Margin

Operating Margin

Profit Margin

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Operating Expenses

Year over year growth in Revenue and Operating Expenses.

Revenue Y/Y

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Growth

Operating Cash Flow

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Outstanding Shares

Market Cap

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Revenue Multiple

Alphabet dominates the online search market with 90%-plus global share (80%-plus US share) for Google, and the business generates very strong cash flow. We expect continuing search growth as we remain confident that Google will maintain its leadership despite Microsoft's move to include generative artificial intelligence in Bing and Google's recent AI missteps. We also foresee YouTube and cloud contributing more to the firm’s top and bottom lines.

Google’s ecosystem strengthens as its products are adopted by more users, making its online advertising services more attractive to advertisers and publishers. With its dominant share of queries globally, Google holds and continues to collect far more information regarding consumer behavior, in terms of both which results are most relevant for a given search term and the ads most likely to generate incremental sales. The firm uses technological innovation to improve the user experience in nearly all its Google offerings, while making the sale and purchase of ads efficient for publishers and advertisers. This innovation has included the use of AI in delivering search results. The introduction of generative AI adds some uncertainty, but we expect Google will ultimately use its information advantage to maintain its dominance. While the business is maturing, we think ad revenue can continue to grow at mid-single-digit rates in the coming years.

Among the firm’s investment areas, Google has quickly leveraged the technological expertise applied to its private cloud platform to expand into the public cloud business. The firm has increased its market share in this area, driving additional revenue growth and creating more operating leverage, which we expect will continue. 

Most of Alphabet’s more futuristic projects are not yet generating revenue, but the upside is attractive if they succeed, as the firm is targeting newer markets. Alphabet’s autonomous car technology business, Waymo, is a good example: Based on various studies, it may tap into a market valued in the tens of billions of dollars within the next 10-15 years.

Business Strategy & Outlook

We assign Alphabet a wide moat rating, thanks to durable competitive advantages derived from the company’s intangible assets, as well as the network effect.

We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and artificial intelligence (machine learning and deep learning), as well as access to and accumulation of data that is valuable to advertisers. We also believe that Google’s brand is a significant asset; "Google it" has become synonymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry. While Microsoft’s Bing is attempting to dethrone Google with AI technology from OpenAI, we think the firm can defend its dominance in search with its own AI technology, some of which OpenAI’s products are based on.

In our opinion, Alphabet’s network effects are derived mainly through its Google products such as Search, Android, Maps, Gmail, YouTube, and more. Ultimately, we view Google’s network as heterogeneous. On one side, all the products Google offers have provided it with a massive consumer base that allows the company to collect data. On the other side, via its rich data collection and large user base, Google can offer advertisers the best return on investment. Adding new advertisers improves the efficiency of Google’s programmatic advertising offerings, allowing the firm to better monetize the network. 

Google Search’s success stems from the relevance of its results to its users and the likelihood that this relevance will improve as more data is gathered and analyzed, assumptions are generated, and predictions are created. The firm has successfully and consistently monetized many of its technology-based intangible assets, from the original algorithms behind search to the current machine learning ones and deep learning-based generative artificial intelligence technologies, which are being applied to nearly every product. While generative AI creates uncertainty in search, we expect the size of Google's revenue opportunity will remain intact. While the volume of clicks may decline, the search engine will have more data regarding user’s interests, which it can use for contextual campaigns for advertisers, increasing spending per click.

For advertisers, value is created mainly through growth of the large user base to target and from behavioral data compiled and analyzed. As users and search requests grow and more data is gathered, advertisers’ demands for ads increase, helping Google to further monetize the network. 

As with Google Search, we see network effects from large and growing user bases of other products, such as Maps, Gmail, and Chrome, all of which create value for users and advertisers. As more consumers use Maps, more data regarding traffic, commuting tendencies, and so forth is gathered, helping Google generate more accurate results (in terms of locations, travel times, and route suggestions). Businesses and advertisers pay Google to place their search ads, targeted based on users’ locations and previous searches, within Maps’ search results list and directly on the map. 

Google's Chrome browser remains the market leader with 65% share, according to StatCounter, compared with 18% for Apple's Safari and 5% for Microsoft's Edge. Chrome browser usage helps increase Google's network effect. In addition, Android positions Google well in the mobile ad market. StatCounter estimates Android OS powers more than 70% of smartphones around the world, compared with Apple iOS' at 28%. We note, however, that Google makes annual payments to Apple and Samsung for its search engine to be the default option on their mobile devices. 

We think YouTube is also valuable, as it benefits from a network effect that creates value for users, content creators, and advertisers. With more viewers on the site today, more content creators look to YouTube for content distribution. YouTube’s video platform has more viewers than other online video properties, making it attractive for advertisers. 

We expect Google to gain a foothold in the growing enterprise cloud market, but we do not think its cloud offerings create a network effect. Although Amazon is clearly the leader in this area, we expect Google to trail only Amazon Web Services and Microsoft’s Azure in market share. Ultimately, we believe Google can leverage the technological expertise (including machine learning and deep learning AI) it applied to creating and maintaining its private cloud platform to build and maintain public cloud platforms for many businesses.

Finally, while Alphabet generates economic profit through Google, which we think will continue, this profit would be higher were it not for Alphabet’s efforts to remain a step ahead in terms of innovation. In its other bets segment, Alphabet is betting on (or investing in) using technology to enhance health (Verily), self-driving cars (Waymo), and much more. Some of these wagers may not bring in any winnings, and we believe it is too early to consider these businesses as contributors to Alphabet’s economic moat.

Wide

Economic Moat

Alphabet

DeepMind Technologies Limited is a British artificial intelligence company founded in September 2010.  Acquired by Google in 2014, the company has created a neural network that learns how to play video games in a fashion similar to that of humans, as well as a Neural Turing machine, or a neural network that may be able to access an external memory like a conventional Turing machine, resulting in a computer that mimics the short-term memory of the human brain.

DeepMind

YouTube is an American video-sharing website headquartered in San Bruno, California. The service was created by three former PayPal employees—Chad Hurley, Steve Chen, and Jawed Karim—in February 2005. Google bought the site in November 2006 for US$1.65 billion; YouTube now operates as one of Google's subsidiaries.

YouTube

Android is a mobile operating system developed by Google, based on a modified version of the Linux kernel and other open source software and designed primarily for touchscreen mobile devices such as smartphones and tablets. In addition, Google has further developed Android TV for televisions, Android Auto for cars, and Wear OS for wrist watches, each with a specialized user interface. Variants of Android are also used on game consoles, digital cameras, PCs and other electronics.

Android

Nest Labs is a home automation producer of programmable, self-learning, sensor-driven, Wi-Fi-enabled thermostats, smoke detectors, security cameras, and other security systems. It introduced the Nest Learning Thermostat in 2011 as its first product. The Nest Protect smoke and carbon monoxide detector was then introduced in October 2013. After the acquisition of Dropcam, the rebranded Nest Cam was introduced in June 2015. Finally, in July 2016, the Nest Cam Outdoor was released.

Nest Labs

Boston Dynamics is an American engineering and robotics design company founded in 1992 and headquartered in Waltham, Massachusetts, and is a wholly owned subsidiary of the Japanese conglomerate SoftBank Group. Boston Dynamics is best known for the development of BigDog, a quadruped robot designed for the U.S. military with funding from Defense Advanced Research Projects Agency (DARPA), and DI-Guy, software for realistic human simulation. Early in the company's history, it worked with the American Systems Corporation under a contract from the Naval Air Warfare Center Training Systems Division (NAWCTSD) to replace naval training videos for aircraft launch operations with interactive 3D computer simulations featuring DI-Guy characters. The company is a pioneer in the field of robotics and it is one of the most advanced in its domain. Marc Raibert is the company's president and project manager. He spun the company off from the Massachusetts Institute of Technology in 1992.

Boston Dynamics

Alphabet, Inc. is a holding company, which engages in software, health care, transportation, and other technologies. It operates through the following segments: Google Services, Google Cloud, and Other Bets. The Google Services segment includes products and services such as ads, Android, Chrome, devices, Google Maps, Google Play, Search, and YouTube. The Google Cloud segment refers to infrastructure and platform services, collaboration tools, and other services for enterprise customers. The Other Bets segment relates to the sale of healthcare-related services and internet services. The company was founded by Lawrence E. Page and Sergey Mikhaylovich Brin on October 2, 2015 and is headquartered in Mountain View, CA.