- Size has become a problem for Alphabet – growth will likely slow from here.
- Once Google’s dominance in internet search shows cracks, it will crumble quickly.
- As a result, I would not bet too much on Alphabet’s moat.
In investing, the “Lollapalooza effect” can mean good and bad things. In this case, I will focus on a series of headwinds mounting for Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), which are probably not that evident for many investors and which are causally linked to each other. Together, they could become a real headache for the company.
Chatting about ChatGPT (MSFT) is not what I intend to do here – I’d rather highlight the manifold likely implications of its emergence and try to quantify their financial impacts.
The curse of bigness
First of all, size is becoming an issue for Alphabet. The global advertising market, according to Statista, was about $800B in 2022, of which Alphabet’s $224B alone represented a whopping 28%. While the total pie is likely to grow further at a mid-single digit CAGR, the days of mind-numbing growth rates are likely over, especially since the share of digital ads is already close to two thirds. This share has grown rapidly over the past decade, virtually guaranteeing high growth rates for the dominant players, but it won’t go to 100% and its progression will slow from here.
Overall, traditional advertising (TV, print, outdoor etc.) probably won’t go much below 30%, since a successful advertising campaign always needs different touch points to be successful. So there is not much overall share increase available to compensate for digital share losses. Probably, Alphabet’s ad revenues will grow from here roughly in-line with the total advertising market, or maybe a bit slower. Certainly we won’t see another decade of compound 18% revenue growth.
Moreover the political debate about the company’s monopoly power is raging on, fuelled by an exceptionally passionate FTC. This could end in rather drastic regulatory interventions, which explicitly doesn’t exclude a break-up.
The problems of dominance
Alphabet’s dominance of the digital advertising market has been the key part of every bull thesis, but in my opinion, it is becoming part of the problem here because the question must be: What happens if that dominance becomes a little less evident?
Unfortunately, at this point any disruptor will likely lead to market share losses for Alphabet.
Actually, this has already happened and has simply been masked by overall market growth. More and more people look for products directly on Amazon (AMZN) which has built a formidable advertising business. Apple is also working on its own ad business. Finally, thanks to ChatGPT, Bing could come into play again.
We don’t need ChatGPT to make Bing the dominant search engine (it likely won’t – disruptions usually play out in much more differentiated ways), we just need it to be perceived as a place where global brands must show their presence. (Microsoft is already working on this.) This would not only take ad budgets to a competitor (thus reduce revenues) it would likely also lead to an increase of Alphabet’s R&D budget (thus reduce profit margins) to counter the threat.
Moreover, Morgan Stanley’s analyst Brian Nowak noted that if only 10% of searches moved to language models, due to their higher compute intensity the increment in operating expenses for Alphabet would be $1.2B. I guess, we can all agree that – if language models will establish themselves within internet search – their share will be higher than 10%.
And what about revenues? Doesn’t more competition normally lead to lower prices? I guess, if Microsoft sees a path to make Bing a competitive search engine, it would be open to rather aggressive pricing strategies.
Finally, if thanks to ChatGPT Bing takes a small, but meaningful share of the internet search market, the infamous ~$15B agreement with Apple (AAPL) which makes Google the default search engine on iOS might come into play. I’ve always found it extremely interesting to think about this agreement: Why would Alphabet sacrifice some ~7% of its ad revenues to secure the top spot, especially given that most iOS users would choose Google anyway? The agreement, in my opinion, highlights how fragile Alphabet considers its moat to be.
This would confirm my thesis: Google will remain dominant as long as it is absolutely dominant. Once small cracks appear, there won’t be any sort of dominance anymore and the beauty of the monopoly would be gone forever.
On this backdrop, how much would Alphabet need to offer once Apple effectively had one or more different choices or if there was a competitive bidder?
“Wasteful spending” and “returning capital to shareholders”
I guess most observers would agree that the tech giants have splurged a lot over the past decade and capital allocation has been not very efficient in most cases. Yet the question needs to be asked how much of this spending is effectively a necessary part of the game – i.e. are we really talking about “wasteful” or more likely about “defensive” spending? In other words: When Meta (META) explores immersive digital worlds, Apple explores computers on four wheels (aka self-driving cars) and Microsoft funds OpenAI, aren’t all other competitors forced to do the same? Isn’t this the key reason for the large, often considered excessive cash hoards on the tech giants’ balance sheets? The digital world moves fast, even giant empires can be disrupted in unforeseen ways, so they need to paranoically prepare for everything. Since the FTC won’t allow them to simply buy the next big thing, everything needs to be developed internally.
So what would happen once profit margins dwindle? As less money would be available for “other bets”, moats would become more fragile.
Yet probably the most important issue for investors has always been stock-based compensation. As Eric Sprague has shown in his recent article, almost all FCF generated by Alphabet has actually ended up in its employees’ pockets. Buybacks have merely sterilized dilution and taxes on RSU awards have made things even worse: Overall, $189B has been spent over the past ten years, which was actually shareholders’ money. Most companies characterize buybacks as a “return of capital to shareholders”, but nothing could be further from the truth in this case: Alphabet has actually taken almost all the profits it generated from shareholders.
Investors have always forgiven this sin simply because the stock performed well until recently. But once the stock doesn’t always go up, investors will request their fair share. This means less money is available for retention of employees and various perks, or dilution will increase, further weighing on the stock.
Implications on valuation
In my opinion, Alphabet’s business will either strive or face a deep transformation with unclear results. Its moat is less robust than it is generally perceived to be. This makes the business less predictable over the long term and therefore less valuable. In other words, despite still good growth prospects in the near term, markets might apply a lower multiple to the company’s earnings, especially since management still hasn’t explained how investors can make a return when all cash profits end up with employees.
If R&D and other operating expenses grow 15% or $12B from here, net profit margins shrink to 17% from 21% in 2022. (Still a great net profit margin!) Coupled with revenue growth of 7% for the next decade, net income in 2033 could reach $95B, for a little more than 50% total growth.
Not factoring in any dilution, this would mean EPS of $7.30. At a 16x multiple, the stock would trade for $117 – not really a great return from today’s $87.
Admittedly, this is probably the bear case.
At this point we can easily see why I mentioned capital allocation and stock-based compensation: Over the next decade, if everything plays out as projected, Alphabet will generate ~$700-800B of FCF. Where will that money go? If it truly returns to shareholders, shares outstanding could easily shrink by about 50%, i.e. EPS would not be $7.30 but $14.60. And the multiple would likely be higher as well. So all in all we might be talking about a stock price above $250 in 2033.
But what if a large part of that money goes into sterilizing dilution, capex-heavy projects or defensive “other bets”? What if management will not exactly have much choices and needs to spend more to counter attacks against Alphabet’s moat? There is a huge variety of potential outcomes.
I am not saying GOOG stock isn’t cheap here. It probably is quite cheap since Alphabet starts the battle from an excellent position and the issues with capital allocation are so evident that the company will have to address them rather sooner than later.
Probably Alphabet will waste a lot less than $700-800B of FCF over the next decade, so at least half of this should effectively return to shareholders. With an effective reduction of shares outstanding by 25%, EPS could reach $10 in 2033 and shares could double until then. If profits grow faster than in my rather bearish scenario, overall the stock could deliver even better returns.
Yet this probabilistic assessment is the result of a wide range of potential outcomes. It’s like driving a heavy truck across a fragile bridge: Once done, everything is great. But the bridge could break.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.