Alphabet's growth engines stall: Can it still fly?

Background

It would not be an over exaggeration to say that for Alphabet, parent company of Google, the last twelve months have been the most challenging period the company has experienced since listing in 2003.

Revenue growth for 2022 fell below 10%. This marked only the second time in the history of the Silicon Valley giant that its annual revenue grew at a single digit rate – one has to go all the way back to the Global Financial Crisis for a similar disappointment. Adding to the company’s troubles are increased efforts by regulatory authorities to reduce Google’s dominance in the advertising space and the recent launch of ChatGPT has led some to suggest that Google’s days may even be numbered.

Is Alphabet not just going through a cyclical downcycle?

Shareholders are used to Alphabet delivering 20% revenue growth on an annual basis so the less-than-satisfactory growth of 9% came as a disappointment. To be fair, the advertising industry is somewhat cyclical and Alphabet’s annual revenue growth has dipped below 20% on the odd occasion though it has consistently averaged around 20% over more than two decades. In this particular instance, the cyclical decline could be ascribed to macro issues such as soaring levels of inflation, rapidly rising interest rates as well as the Russia-Ukraine conflict, all of which contributed to advertisers reducing their advertising spend.

It also needs to be pointed out that the base against which 2022 is compared, specifically the performance of 2021, was relatively high as advertising spend recovered dramatically post COVID.

Headwinds

What may be less apparent is that the growth engines that propelled Alphabet to achieve its regular 20% grow rate may be beginning to lose some steam. New technologies and competitors have begun to challenge Alphabet and structural issues threaten to curb its future growth prospects.

From a competition standpoint, perhaps the most talked about threat to Alphabet is ChatGPT. To understand why this is potentially a significant threat to Alphabet, one first needs to understand how Alphabet makes money. Almost the entire revenue base of Alphabet can be ascribed to Google which in turn makes over 80% of its revenue from advertising. The majority of Google’s advertising is generated from search, making it the crown jewel in the Google stable. Since the late ‘90s Google’s search engine has grown in popularity before becoming the most used search engine at the start of the century. Fast forward two decades later and Google has become the de facto search engine with over 90% market share. Google not only held onto its lead but actually increased its already dominant position over the past two decades as no other company or product has been able to successfully challenge Google’s seemingly impenetrable moat.

Enter ChatGPT – it may have found the key to unlock the kingdom – artificial intelligence (“AI”). For those that have not heard of ChatGPT, it is a chatbot powered by AI. In simplistic terms, ChatGPT is a computer model or what is referred to as a large language model (“LLM”), that has been “trained” to recognise patterns or structures.

In this case the structure the model is trying to learn is a language, hence LLM, using vast quantities of data so that it can understand what is being asked of it by a user and then perform tasks following the user’s questions or prompts. The user can ask the chatbot questions in a conversational format, essentially “searching” for the answer. Many have suggested that ChatGPT is the next evolution in search with some even labelling it a “Google killer” as search queries could migrate to this new and seemingly improved format. This would lead advertisers to redirect their spend away from Google, effectively draining its moat.

Another competitive force facing Alphabet, specifically its video streaming platform YouTube, is TikTok. As the Chinese-owned platform grows in popularity, advertisers are likely shifting more advertising dollars away from established platforms such as YouTube.

Sticking with YouTube, it faces an additional headwind brough about by Apple’s App Tracking Transparency (“ATT”) initiative. ATT is a privacy policy that allows iPhone users to determine whether they want to share their data with third parties – incidentally, most iPhone users opt not to share. Prior to ATT, third parties were able to collect data from an iPhone user, tracking where they live, where they work, what stores they visit, what they searched for, streamed and downloaded. In aggregation, this data could be used to create an accurate profile of an iPhone user, information that would be incredibly useful for advertisers when it comes to targeting customers.

Following the introduction of ATT, the lack of tracking data has led to profiles becoming rather blurry making it more difficult for advertisers to target customers. Apple’s privacy initiative has created quite a headache for social media platforms, such as YouTube, that use targeted advertising, as it has degraded the value of advertising spend on said platforms ultimately leading to advertisers shifting their dollars elsewhere.

Five years ago, Google and Meta (previously Facebook) captured over 50% of digital advertising spend in the US. While digital advertising spend has continued to grow, the share captured by these two companies has declined and last year it fell below 50%. Companies that may have used the likes of Google (and Meta) in the past to advertise their products and services are now growing their own digital advertising businesses, specifically in the area of e-commerce.

Last year, Amazon’s digital advertising business generated $38 billion as it increased its market share in the US to around 15%. Even the likes of Walmart have waded in the digital advertising space creating further competition for digital advertising dollars. Strengthening the growing competitive position of e-commerce players is the ATT initiative. A customer engages directly with Amazon when making a purchase, enabling Amazon to create a far more complete profile compared to other social media platforms which would certainly be of more interest and value to advertisers.

Competitive forces have certainly been and are likely to continue to act as a headwind for Alphabet but perhaps the bigger concern, at least in terms of growth prospects, lies in the current structure of the advertising industry. As mentioned,  advertising is a somewhat cyclical industry but it must be noted that it is fairly consistent in terms of its size relative to a country’s GDP (gross domestic product).

In the US for example, the world’s largest market for advertising, advertising spend has consistently averaged between one and one and half percent of GDP. This would imply that the advertising industry grows at roughly the same rate as the economy.  However, Google has managed to grow at a much faster pace owing to the disruptive nature of the internet and the impact of digital advertising.

Put differently, over the past two decades, while advertising spend as a percentage of GDP has remained fairly consistent, there has been a dramatic shift from traditional formats such as print and to a lesser extent television, towards the internet, initially the PC and then mobile following the proliferation of smartphones. As it currently stands, digital advertising is now the dominant format comprising more than two thirds of a $700-800 billion industry. Assuming advertising budgets remain consistent, this creates somewhat of a dilemma for the likes of Google.

The growth engine that has propelled it to consistently high levels of growth, the disruption of the advertising industry, may be running out of steam as there are less avenues to disrupt. This would lead to a deceleration in growth as it converges towards that of the broader economy.  The runway is set to narrow.

Some push-back

The above headwinds are enough to give one pause as to whether they should continue to keep Alphabet in their portfolio but before pushing the eject button, further consideration needs to be given to the above headwinds beginning with the potential threat of ChatGPT.

There are still so many unknowns that accompany the use of AI powered chatbots for search. It is still quite uncertain how search will evolve through the use of these LLMs and how many search queries will migrate away from traditional search towards these more sophisticated chatbots. Even more uncertain is how to monetise the use of such bots as it would require a different business model compared to what is currently used. It may have been beaten to the punch but Alphabet has already launched a ChatGPT competitor. Alphabet has named its chatbot or conversational AI chat service “Bard”  which is powered by its own LLM that has been development for some time already.

Given Alphabet’s sizable R&D investment into AI, it is quite possible that it could produce an even better version than ChatGPT. That said, the initial launch was somewhat of a flop and came across as unprepared and smelling of panic as Alphabet’s CEO stumbled through an error-ridden presentation.

To reiterate, how AI will change the area of search and advertising remains a big unknown at this point in time but what is more certain is that the cost of running queries on ChatGPT or Bard will be more expensive than traditional search queries. This is because such queries are more energy intensive and need to be run on processors capable of handling such computations, namely GPUs (Graphic Processing Units) from Nvidia and TPUs (Tensor Processing Units) from Alphabet.

The higher cost, be it opex or capex, is likely to depress Alphabet’s margins and ultimately its return on capital – at least in the short-to-medium term.

While it may appear that Alphabet is running out of runway to disrupt, this could in fact be less of a concern as we move into an increasingly digitalised world. With more storefronts moving online, as opposed to traditional brick-and-mortar layouts, expenditure that would normally be allocated to physical space, be it rent or even the purchase of a building, could instead be allocated to more warehouse space as well as logistics and shipping.

Importantly, in a digital world, a company’s reach can move from local to global and this means spend on increasing customer reach can grow and lead to further growth in digital advertising. The implication of this shift could potentially see advertising spend as a percentage of GDP increasing in the future. Analysts estimate that digital advertising will grow at a rate in the high single digits to low teens over the next few years. This level of growth is certainly below the historical 20% rate but compared to many other industries the moderated rate of growth remains attractive.

In somewhat of a plot twist, the threat that TikTok poses to western social media and entertainment platforms such as YouTube could potentially be neutralised by governments in these regions. Experts have raised concerns that user data is being used to spy on American and European citizens as well as spread propaganda in the regions. Whether or not a complete ban will be implemented remains to be seen but such a move would certainly be beneficial for the likes of YouTube.

Looking ahead

The point of this article was not to read a coroner’s report for Alphabet, highlighting all the reasons that the company is likely to underperform. Nor was it written to downplay the headwinds that are currently facing the company. Rather, the intention was to provide the reader with our reasoning as to why we believe Alphabet is likely entering into a new phase in its life cycle, where growth is likely to be slower than the past and returns on capital are expected to come under pressure due to a growing number of competitive forces the industry.

Does this mean that Alphabet is no longer worth holding? Some may prefer to move on from Alphabet in search of the next batch of companies that are able to deliver 20% growth. For others, despite an increased likelihood of slower growth and lower returns on capital, Alphabet still stands out as a company that exudes the characteristics of quality and growth. One would be hard pressed to find many other companies that will be able to grow revenues at high single digits or in the low teens whilst also generating gross margins in excess of 50%. At a stock price of around $100, the market seems quite pessimistic about the prospects of Alphabet as expectations baked into the stock price suggest that the market expects little-to-no growth from the company as well as a notable contraction in its margins.

One could also argue that for some time now, Alphabet’s share price and market (multiple) valuation have reflected a somewhat pessimistic view of the company with many concerned over antitrust issues facing the company.  We are of the view that the market continues to underappreciate Alphabet’s potential. Even at a lower growth trajectory, its current valuation remains unbefitting of a company that possesses such attractive quality and growth characteristics, two characteristics that are central to our global equity investment approach.