Should You Invest In The Company That Owns 92% of the Global Search Engine Market?

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Introduction 

Just “Google” it.

Conventional wisdom states that any company that can turn their product into a verb has to have an insane amount of competitive advantage.

But does it always?

The fundamental need for a business is to generate profit.

Stronger businesses move on to build in high levels of competencies to make it difficult for competitors to enter the market.

Businesses at the highest level make it virtually impossible for competing businesses to penetrate the market, becoming like a monopoly where they can dictate market prices.  

A quick look at Google, the main business for Alphabet, shows that it commands 92.19% of the global search engine market share worldwide: 

Bing, owned by software giant Microsoft and the second in search engine ranking, lags far behind.

Google’s market share is easily more than 10 times of its next top 5 competitors combined. With its dominance in the search engine and ownership of video content publisher Youtube, Google makes most of its revenue via advertising.  

Alphabet’s most recent quarterly results showed a strong increase of 19% as compared to the previous quarter.

However, for a company that has experienced typical growth rates of 30-40% in the past decade, the bigger questions to ask will be if Google can continue to grow, and, what unique challenges and opportunities are facing. 

Challenges 

More recently, Google has faced backlash due to the way they managed their services.  

In June 2017, the European Commission announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.42 billion (approximately $2.74 billion as of June 27, 2017) fine.  

In the European Union (EU), Google will need to take extra care in ensuring that this does not occur again while adhering to the stricter General Data Protection Regulation (GDPR) rules imposed in the EU. 

In the US, with the upcoming elections in 2020, forerunners of presidential race like Elizabeth Warren explicitly called for the breaking up of giants in the tech industry, including Amazon, Facebook and Alphabet.  

So how successful can politicians be in breaking up a company they deem to be a monopoly? A look into the past shows that Microsoft faced similar issues where the initial judgement of the case was to break up Microsoft. Only after extensive discussions were held and concessions were agreed upon did the Department of Justice (DOJ) determine that it was no longer seeking to break up Microsoft. While the whole case was long (1998 – 2001) and would have generated huge costs for the company, Microsoft eventually came up tops and this precedent would be a powerful one for Google to study and follow if such a lawsuit comes their way.  

Competition 

Alphabet has a deep understanding of their competitive landscape and has provided the following: 

Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from:  

  1. General-purpose search engines and information services, such as Baidu, Microsoft’s Bing, Naver, Seznam, Verizon’s Yahoo, and Yandex.  
  2. Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Kayak (travel queries), LinkedIn (job queries), and WebMD (health queries) 
  3. Social networks, such as Facebook, Snap, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines.  
  4. Other forms of advertising, such as billboards, magazines, newspapers, radio, and television.  
  5. Other online advertising platforms and networks, including Amazon, AppNexus, Criteo, and Facebook, that compete for advertisers that use AdWords, our primary auction-based advertising platform.  
  6. Providers of digital video services, such as Amazon, Facebook, Hulu, and Netflix.  
  7. Companies that design, manufacture, and market consumer electronics products, including businesses that have developed proprietary platforms.  
  8. Providers of enterprise cloud services, including Alibaba, Amazon, and Microsoft.  
  9. Digital assistant providers, such as Amazon, Apple, and Microsoft. 

My personal take is that vertical search engines pose the biggest threat to Google.

Advertisers are seeing that attaining spots where a user is most likely to purchase the product is key. Thus, more ad spend has been shifting towards platforms like Amazon where their advertising segment grew 36% in the past quarter, hitting $2.7 Billion for their first quarter, a growth rate analysts consider a “slowdown”.  

When we look at the other side of the world in China, we see Baidu struggling even in its home market. It will seem that fast-growing apps like Toutiao and Tiktok have rapidly changed how Chinese consumers get the content they want.

This trend of not going to traditional search engines to find the content required will continue to grow and this may lead up to become Google’s biggest challenge to their core search product.  

Moonshots 

Typically when one considers investing in Alphabet, the business that gets considered is only Google.

However, the shift to become Alphabet as the holding company was done to imbue processes so that other subsidiaries focusing on a wide range of industries can thrive. 

Some of them include Waymo which is the current world leader in Autonomous Vehicles and Calico and Verily that explore breakthroughs in healthcare.  

Alphabet calls these projects and companies their moonshots with a further explanation and elaboration on why they are critical: 

Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. As we said in the original founders’ letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. 

For instance, Nest recently expanded its connected home product line by introducing the Nest Thermostat E and a new home security solution that includes the Nest Hello video doorbell, Nest Cam IQ outdoor security camera, and the Nest Secure alarm system.

Our self-driving car company, Waymo, continues to progress the development and testing of its technology and now has a fleet of vehicles in Phoenix, Arizona, driving without a person behind the wheel. Life sciences company Verily has also made significant progress on key programs, like the launch of its Project Baseline study with Duke University and Stanford Medicine, and received an $800 million investment in 2017 from Temasek to accelerate its strategic programs.“ 

A deeper dive into Waymo shows that this moonshot project has been attached high valuation prices by analysts, with prices ranging all the way from $25 billion to $250 billion from companies like UBS, Morgan Stanley and Jefferies. The promise of self driving cars have also got many venture capitalists intrigued, with their investments reaching $4.2 billion in the first three quarters of 2018.  

Knowing that the risk for such moonshot projects is high, Alphabet has made the deliberate choice not to fully bear it. For example, they raised $800 million from Temasek for Verily though they had the financial means to do it. This signifies financial prudence on their part.  

Financials and Dividends 

Currently, Alphabet has a huge reserve of cash. It is now the most cash-rich company, overtaking Apple, with $117 billion in liquid reserves. Some may think that Alphabet will now seriously consider providing dividends to investors.

However, according to their latest annual report, Alphabet states that their Dividend policy: “We have never declared or paid any cash dividend on our common or capital stock. We intend to retain any future earnings and do not expect to pay any cash dividends in the foreseeable future.” 

My personal take in this is that Alphabet’s strong suits include strengthening the current business and investing in new businesses. To give a dividend may signify that they do not see good opportunities to further invest. 

That being said, as a Singaporean investor, it is also not in our best interest to invest in U.S. stocks providing dividends as 30% of it will be reduced as withholding tax. A withholding tax, or a retention tax, is an income tax to be paid to the government by the payer of the income rather than by the recipient of the income. This effectively only allows you to obtain 70% of the dividend.  

However, understanding that investors need to be rewarded in the short term too, Alphabet has announced a $25 billion share buyback plan which in net effect will increase share prices since there is less supply of shares in the market.   

Diving deeper into the financials, we can see that on an overall basis, the stock price and earnings per share has been on an uptrend, with the stock price more than doubling since 2015 and latest earnings per share more than doubling from $20.97 beginning 2015 to $49.54 as of latest quarter in 2019. 

Ignoring the abnormalities in 2017 of low earnings per share, we can also observe that the current Price to Earnings (PE) ratio is significantly lower than it’s average. (Current: 24.2 vs Average: 27.9 after being more conservative and taking out a full year of high PE ratios due to lowered earnings in 2017 and 2018.) 

This will mean that at current valuations, Alphabet is now trading lower than historical valuations.  

 https://www.macrotrends.net/stocks/charts/GOOG/alphabet/pe-ratio as of 20/08/2019 

Believing that Alphabet will continue to be able to drive growth via Google and through their moonshots is critical for the potential investor.  

Class Matters

If you’re convinced to be an investor in Alphabet, you’ll have to make another decision on what class of shares to purchase. 

Alphabet has 3 classes of shares, namely Class A, B and C. The reason for splitting into several classes is to preserve decision making control for the founders.  

A summary of the class structures: 

  • Class A—Held by a regular investor with regular voting rights (GOOGL) 
  • Class B—Held by the founders and has 10 times the voting power compared to Class A 
  • Class C—No voting rights, normally held by employees and Class A stockholders (GOOG) 

The ones trading in the market are only Class A and Class C. As seen from the following charts, overall the prices move in tandem. However, Class A will be considered more valuable as there are attached voting rights. With the current price gap being so low at just only about $1, I would say it makes a lot more sense to go for Class A. Taking a price at a random point say 21 Dec 2018, Class A was worth $991.25 while Class C was worth $979.54. The difference is more than $10.  

Conclusion 

In summary, Alphabet has very strong cash cows like Google that commands over 90% of the search engine market and Android with 76.08% of the mobile operating system market share as of July 2019.

It too owns very promising assets like Waymo and Verily that aims to disrupt the transportation and healthcare markets respectively.  Becoming an investor in Alphabet means believing in the future kind of world they are trying to build. Without a doubt, it will be a wild and exciting ride.  

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