ALPHABET INC. Growth engine with monopoly power November 26, 2021 102

PSR Recommendation: ACCUMULATE Status: Initiation
Target Price: USD3380.00
  • Following a blistering 110% spike in earnings this year, we expect another 20% growth in FY22e. The pandemic has accelerated the adoption of digital advertising and GOOGL monopolises online search market with a 92% share.
  • YouTube is making huge strides in commercialising its services via digital ad placements, and monetary incentives for content creators. Consumer preferences tilting towards short-form and on-demand video.
  • Google Cloud is expected to grow faster than the industry’s 21% CAGR due to its aggressive go-to-market strategy, backed by an increase in digital transformation projects globally.
  • Initiate coverage with an ACCUMULATE recommendation and DCF-based target price (WACC 6.9%) of US$3380.00.

 

Company Background

Alphabet Inc. operates as a holding company with subsidiaries providing web-based search (Google), advertisements, maps, software applications, mobile operating systems (Android), consumer content (YouTube), enterprise solutions, commerce, and hardware products.

 

Investment Merits

  1. A monopoly with growth. Google monopolises online search with its 92% share. We continue to see GOOGL’s digital advertising revenue grow from strength to strength, led by the company’s immense global reach and a diversified product portfolio capable of capturing multiple consumer touch points. Macro shifts in trends towards more digital forms of advertising, as well as an increasing amount of digital transformation projects globally should provide tailwinds to support PATMI growth. Net margins are also expected to widen 8% by end FY22e, led by strength in verticals like digital advertising and cloud services which have high degrees of operating leverage.

 

  1. Commercialising YouTube as additional growth driver. YouTube is GOOGL’s fastest growing product, more than doubling revenue over the last 3 years to US$20bn FY20 (12% of total revenue). YouTube has been commercializing its services through digital ad placements on its platform, sharing a portion of its ad revenue with content creators, incentivising them to produce more content with the goal of attracting more users. This strategy has allowed YouTube to grow in scale and reach, with more than 2 million content creators, an estimated 2 billion monthly users, and over a billion hours of video watched daily. We expect YouTube revenue to continue growing at this rate and hit US$36bn by FY22e, led by strength in its advertising reach and effectiveness, and supported by increases in consumer preference for short-form, and on-demand video.

 

  1. Large growth potential in Cloud. Google Cloud has been the company’s fastest growing segment over the last 3 years, growing at a 3-yr CAGR of 48%, with revenue of US$13bn in FY20 (Figure 4). We expect this segment to continue its strong growth pattern and double revenue by end FY22e, as the company rides tailwinds from early-stage growth in the overall cloud industry. Google Cloud is currently the 3rd largest cloud provider in terms of market share (IaaS, PaaS, Cyber Security), growing as fast as Microsoft’s Azure, and faster than industry leader Amazon Web Services. We expect Google Cloud to maintain this position moving forward given the company’s continued CAPEX spend to boost its cloud infrastructure and its aggressive go-to-market strategy.

We Initiate coverage with an ACCUMULATE rating and a target price of US$3380.00 based on DCF valuation, with a WACC of 6.9% and terminal growth of 4%.

REVENUE

GOOGL posted US$182bn in revenue for FY20 – growing 13% YoY, with 92.5% of its total revenue coming from its Google Services segment, 7.2% from its Cloud segment, and the remaining 0.3% from Other Bets (Figure 5). In terms of revenue breakdown by geography, 47% of revenue comes from the US, 30% from EMEA, 18% from APAC, and 5% from other regions (Figure 9). Gross Profit for FY20 was US$98bn, with gross margins of 53.6%. PATMI was US$40bn, with net margins of 22.1%.

 

Google Services: This segment can be divided into two portions, Advertising (87%), and Other Services (13%). As the name suggests, revenue derived from all forms of advertising fall into the first portion, and revenue from in-app purchases, hardware sales, and subscription fees fall into Other Services. Advertising brought in US$147bn in revenue for FY20, with Other Services recording US$22bn in revenue. Advertising can be further broken down into three main components: Google Search, YouTube Ads, and Google Network Members’ Properties.

 

Google Search is the segment’s main revenue driver, with revenue of US$104bn in FY20 (62% of services revenue, and 57% of total revenue), and includes advertising revenue generated on Google search properties, as well as revenue from other products like Gmail, Maps, and Google Play (Figure 10).

 

YouTube brought in US$20bn of revenue in FY20, and mainly consists of ad revenue generated on YouTube properties. It has been the fastest growing vertical within Google Services for the last 3 years, with revenue increasing at a 3-year CAGR of 34% (Figure 11), compared to overall segment growth of 17%. The platform has seen an increase in adoption rate, both from content creators, as well as users, with more than 2 million content creators, an estimated 2

billion monthly users, and over a billion hours of video watched daily. This strong growth in adoption has been a result of GOOGL’s increasing efforts to commercialise YouTube through digital ad placements, which are placed on every video content on the platform. These ad placements incentivize content creators – who get paid with each additional ad-click on their videos, to generate more content, which in turn attracts more users onto the platform. We expect YouTube revenue to continue its high growth rate, supported by strength in user reach and advertising effectiveness.

 

Google Network Members’ Properties recorded revenues of US$23bn for FY20, and they are mainly derived from revenue generated from Google Ad Manager, AdSense, AdMob. The products in this component are generally geared towards helping publishers create, manage, and track their direct ad response campaigns.

 

Revenue from the entire Google Services segment was US$168bn for FY20, increasing 11% YoY, driven mainly by retail advertisers as global spending continues to increase.

 

Google Cloud: This segment includes Google’s infrastructure and data analytics platforms, as well as other enterprise solutions, and are split into two main properties: Google Cloud Platform (GCP), and Google Workspace – formerly known as G Suite. Google Cloud recorded revenue of US$13bn in FY20, and is currently the fastest growing segment in the company, with a YoY growth rate of 46%. The company focuses on building products in the IaaS, PaaS, and Cyber Security space.

Other Bets: This segment contributes the smallest portion to total revenue, at only US$0.7bn in FY20. Revenue in this segment is primarily derived through licensing and R&D services.

 

Growth Trajectory: We see strong growth potential in a couple of segments and verticals. In terms of digital advertising, we expect YouTube Ads to continue being the fastest growing vertical in the Google Services segment, with revenues projected to grow 82% and hit US$36bn by the end of FY22e. This comes as we see continued adoption of smartphones and streaming services acting as tailwinds for increasing spend in video advertising moving forward.

 

In terms of cloud opportunities, we continue to see Google Cloud as an undervalued opportunity for GOOGL moving forward. Google Cloud has firmly positioned itself in 3rd place  in the global cloud market, and is growing as fast, or faster than its main competitors Microsoft Azure and Amazon Web Services (figure 12). Google Cloud has also been the company’s fastest growing segment for the last 3 years, growing at a 3-yr CAGR of 48%. We expect this to continue moving forward, as the company rides tailwinds from the overall cloud industry which is still in its early stage of growth.

 

Revenue Growth: We expect total revenue growth for FY21e to hit US$253bn, which would represent a 39% YoY growth. In terms of revenue growth by segment, we forecast Google Services to increase 38% YoY (US$233bn), Google Cloud to jump 46% YoY (US$19bn), and Other Bets to rise 17% (US$0.8bn).

 

Other Income: GOOGL recorded other income of almost US$7bn for FY20, increasing 27% YoY, representing almost 4% of total revenue. This was mainly due to net interest income of US$1.7bn, and a US$5.6bn net gain on equity securities.

RULE OF 40

The “Rule of 40” was first introduced as a benchmark to measure the balance between growth and profitability of SaaS companies, taking into account both revenue growth, as well as profitability (Revenue Growth + EBITDA Margins), with the addition of both metrics needing to exceed the 40% threshold. We have modified this slightly by averaging revenue growth over a 3-year period compared to just a single period growth rate. Adding together GOOGL’s 3-year average revenue growth of 18.1% and its EBITDA margin of 30.1%, the total of 48.2% is > than our required threshold of 40% (Figure 8).

EXPENSES

The cost of sales grew 18% in FY20 to US$85bn, largely due to an increase in content acquisition for YouTube, as well as increasing Traffic Acquisition Costs paid to distribution partners. Operating expenses include research and development (15% of revenue), sales and marketing (10%), and general and administrative (6%). Total Operating Expense as a percentage of revenue has been reducing over the last 4 years, from 35% in FY16 to 31% in FY20, and we expect this trend to continue as the company grows its high operating leverage businesses.

CAPEX for FY20 was US$23.3bn (12% of revenue), a slight decrease from US$23.5 in the previous year. We expect CAPEX to increase moving forward, in line with GOOGL’s guidance about bolstering its IT infrastructure to better support its services (Figure 13).

MARGINS

GOOGL has seen a steady decline in gross margins over the last few years, decreasing from 61% in FY16 to 54% in FY20. This was largely due to the company’s aggressive investments in expanding its Cloud business as they play catch-up with cloud leaders Amazon and Microsoft. However, we do see GOOGL’s gross margins reversing this trend moving forward, as its Cloud business turns the corner on profitability.

Net margins in FY20 were 21%, remaining relatively flat over the last few years. We expect net margins to jump significantly in FY21e to about 29%, based on increases in efficiency and scalability of its high operating leverage businesses (Figure 14).

BALANCE SHEET

Assets: Cash and cash equivalents increased by about US$8bn YoY in FY20, largely due to significant increases in cash flow from operations, partially offset by an increase in purchases of non-marketable securities. Marketable securities increased US$9bn, led by a combination of increasing net purchases, and increases in unrealized gains on securities held. Plant, property and equipment for FY20 was US$85bn, an increase of US$9bn from the previous year, largely due to continued CAPEX spending on IT infrastructure and facilities. The company’s current ratio for FY20 was 3.1.

Liabilities: Current liabilities for FY20  were  US$57bn, almost US$12bn more than FY19. This increase was mainly due to  a rise in accruals. Non-current liabilities saw a jump of US$11bn in FY20, largely due to a US$10bn issuance of fixed-rate senior unsecured notes. GOOGL’s debt-to-equity ratio remains low at only 0.06.

CASH-FLOW

Free Cash Flow (FCF) in FY20 was US$43bn, a 38% increase from FY19. We expect FCF to continue growing well due to an exponential increase in cash from operations.

BUSINESS MODEL

GOOGL has evolved over time from a company that provides answers to peoples’ questions, into one that now helps resolve these questions. GOOGL’s revenue is driven by 2 main segments categorized under Google Services, and Google Cloud. It’s 3rd segment, Other Bets, include projects with a long term view in mind.

 

Within the Google Services segment, the products on offer cover almost the entire internet, ranging from services that provide answers to people who seek them — Search,  and navigation services – Maps, to on-demand entertainment – YouTube. The strength of this segment is a combination of a heavily diversified products portfolio, and its scalability and reach. Most of the revenue generated from Google Services falls into advertising revenue, which the company generates from selling ad-placements, as well as targeted ad campaigns to advertisers. The segment generated US$55bn in operating income for FY20, an 11% YoY increase.

 

GOOGL’s other main segment, Google Cloud, has become the company’s fastest growing segment in recent times, growing at a 3-year CAGR of 48%, with revenue from this segment as a  percentage of total revenue almost doubling from 3.7% in FY17, to 7.2% in FY20. Products within this segment are geared towards enterprise solutions, with a focus on IaaS, PaaS, and Cyber Security. The two main components are  GCP and Google Workspace – formerly known as G Suite, focusing on producing collaborative tools that leverage Artificial Intelligence and Machine Learning technologies to improve business efficiency. Revenue for this segment is primarily generated through subscription fees received for the use of its services.

When it comes to data privacy, GOOGL has also taken several initiatives in an effort to  support its users, while preserving strength in its core businesses. The company has promised to remove 3rd party cookies on Chrome by late FY23e, while also refusing to implement alternative tracking methods. We believe GOOGL also has the capacity to collect sufficient first-party data through its multiple touch points to maintain effective advertising campaigns, which should position them well in an environment with stricter data privacy standards.

INDUSTRY

Due to the plethora of products covering multiple industries, GOOGL faces competition from other search engines, social media companies, video service providers, cloud providers, tech hardware manufacturers,  and a host of competitors in smaller verticals. However, GOOGL is still the industry leader in its two main segments: Digital Advertising, and Cloud Services. It also holds a significant market share for many of its products.

 

Google Search. Search is by far the most dominant general online search engine, with over 92% market share globally, and 87% domestically in the US. It has high barriers to entry due to the high fixed costs of servers associated with crawling and indexing the entire internet. It is also the default search provider on 87% of desktop computers.

 

Android. Android is the most dominant mobile operating system in the world, running on roughly 75% of the world’s mobile devices. Even though GOOGL does not monetize Android, it does require mobile phone manufacturers seeking to use Android as an operating system to sign licensing agreements that dictate how certain GOOGL apps have to be pre-installed, and placed in prominent spaces on these devices, extending the visibility of such products from desktop to mobile. In addition, Android provides GOOGL with real-time market data on its users and developers which GOOGL can monetize through its advertising business.

 

Play Store. Play Store is the primary app store on all Android devices, essentially serving as a sentinel for software distribution on mobile devices. It generates revenue by charging developers commissions of up to 30% on application downloads, as well as in-app purchases.

Chrome. Chrome is the default web browser for all things GOOGL, and has become a global leader in web browsers since its inception in 2008. It is estimated to have about 66% of overall web browser usage globally, partly because it is the default web browser on all Android devices. It also has strong network effects which act as its moat, where web developers are attracted to Chrome because of its large user base, and users are attracted to the browser because of its usability and compatability in running an array of webpages. While GOOGL does not monetize Chrome, the product acts as a gateway for users to other GOOGL products such as Google Search and Google Workspace.

 

Maps. It is estimated that GOOGL dominates the digital maps market with over 80% market share split between Google Maps and Waze – which it acquired in 2013. It is likely to maintain this dominance moving forward due to the high barriers to entry – high fixed costs for mapping data. GOOGL is in the early stages of monetizing its digital maps products, by selling map advertising to businesses aiming to maximize foot traffic.

 

YouTube. YouTube is GOOGL’s fastest growing product, and revolves primarily around video entertainment. With more than 2 million content creators, an estimated 2 billion monthly users, and over a billion hours of video watched daily, YouTube is the 2nd most used social media platform globally. Revenue is mainly generated through sales of digital advertising placements to marketers, although it recently introduced a premium subscription service that allows users ad-free videos and music, as well as other premium features. The increasing preference and consumer adoption of short-form and on-demand video services should support growth for this product moving forward.

GOOGL has been riding the tailwinds in the digital advertising industry, and we expect this trend to continue moving forward, based on changing consumer behaviour and increased digitalization globally. Worldwide digital advertising spend is expected to continue increasing over the next 4 years at a 11% CAGR (Figure 15), which we believe GOOGL is well positioned to capture as the industry leader. It’s main competitors in this space are Facebook, Twitter, Snapchat, and Amazon.

 

For Cloud, GOOGL has been outpacing its competitors in terms of growth, with a 3-year CAGR of 48%. Within the IaaS and PaaS sectors, GOOGL is currently in 3rd place with a 7% market share, behind Microsoft’s Azure and Amazon’s AWS, and we expect them to solidify this position with its increasing CAPEX spending on cloud infrastructure. With the overall cloud industry expected to see a 21% CAGR over the next 3 years (Figure 16), we believe there is ample room and tailwinds from the industry to support an expansion of GOOGL’s services and market share in the industry. Competitors in this segment include Amazon, Microsoft and Alibaba.

 

RISKS

  1. Ongoing antitrust lawsuits. GOOGL has continuously been involved in antitrust lawsuits over the last few years, both from regulators in the US, as well as abroad. Most of these lawsuits have resulted in fines without significant impact on operations, although there have been suggestions that tougher consequences – breaking up the company, should be imposed. As long as the outcomes of the lawsuits remain solely as fines, we view these risks as relatively benign.

 

  1. Potential for stricter data privacy regulations. We see a continued focus by regulators in attempting to impose stricter data privacy regulations, and we think that it is only a matter of time before such regulations are passed. These regulations could provide a significant headwind for companies that rely heavily on data to drive their business, which GOOGL does. The company has been attempting to mitigate these risks by tightening its internal policies on data collection to stay ahead of potential future regulations.

VALUATION

We initiate coverage on Alphabet Inc. with an ACCUMULATE rating and a price target of US$3380.00. Our valuation is based on DCF, using a 6.9% WACC and 4.0% terminal growth rate.

 

 

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About the author

Profile photo of Jonathan Woo

Jonathan Woo
Research Analyst
PSR

Jonathan covers the US technology sector focusing on internet companies. Formerly a national and professional athlete, he graduated from the University of Oregon with a Bachelor’s Degree in Social Sciences.

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