- The world's second largest company by market cap has a major problem.
- Their core revenue stream is being threatened by a social media giant.
- Revenue diversification is the need of the hour, and they need to move fast.
On the surface, a company that grew from a little over $10.5 million to $75 billion in a decade is a company you can’t really have a gripe with. But Alphabet Inc-C (NASDAQ:GOOG) now faces a serious problem.
The company’s revenues are overly dependent on one major channel - advertising income - with more than 90% of its annual revenue being derived from that channel.
This lack of diversification may not be apparent because Google offers so many product lines. Unfortunately, the monetization of the bulk of those products only happens through advertising. Android, Google Apps for Work, YouTube Red, Google Cloud Platform and a couple of others are the only real alternative sources of income, but those numbers aren’t significant enough to match ad revenues.
Competition from Facebook
On the advertising front, Google faces increasing competition from Facebook’s network of advertisers. Now that Instagram and Facebook essentially operate off the same Facebook ad interface, it compounds the problem for Google.
Earlier this year Facebook announced that it had officially crossed the 3 million advertisers mark on its platform. Just over a year before that, they crossed 2 million. That means they’re currently growing their advertiser base at around 50% year-over-year. Last year, Business Insider reported that Google’s advertiser base could be upwards of 4 million, so they’re not that far ahead of Facebook.
New Competition from Netflix, et. al.
Now that YouTube Red is online, Google has one more potential revenue stream to offset the threat to their ad business. However, Red is still unproven against monsters like Netflix, Amazon Prime Video and even HBO Now.
At Alphabet’s last earnings call, Google CEO Sundar Pichai said that the six original programs they launched with was only the beginning, with more expected to be made available through the year.
While there’s no doubt that Google has the budget and the global reach to promote YouTube Red effectively, it’s still far too early to make assumptions about how big it will grow.
The point I’m making here is that this particular revenue stream is not one that Google can afford to count on as a future growth driver - not until they see some real revenue traction and long-term gains in subscriber loyalty.
What Are The Options?
As of now, there are just a few additional revenue drivers that Google can really depend on:
- Android apps revenues
- Google Cloud Platform
- Google Apps for work
I’ve identified these three because they are the ones that are being actively driven forward quarter-over-quarter.
Android is obviously a big bet for them because it’s almost self-perpetuating. Every new device manufacturer necessarily looks at using Android as their operating system because it’s open source, it has a ton of apps on Google Play and it’s well received by more than 80% of the world’s smartphone market.
In the graphs below, however, we can see that Google Play’s downloads are far more than Apple’s, but generate only about 50% of the revenue that the iOS App Store does.
Obviously, this is one area that Google can really push hard in, and they’re already incentivizing developers more than ever before. They’ve recently launched an Android Skilling Program in India to train 2 million developers on Android dev skills over the next three years.
In addition, they recently announced a change in the revenue split for app subscriptions, moving from the current 70/30 to 85/15 in favor of the developer - similar to Apple, but with an earlier start.
The intention is to lure more developers into the Android fold in a growing mobile app market that’s set to break the $100 billion barrier in the next 5 years.
Source: App Annie
Google Cloud Platform (GCP) is another area they can take advantage of but have been slow in. Despite being one of the four top cloud providers, their quarterly revenue from the cloud is still under $1 billion - less than half what the others are reporting.
From their Q1 earnings call:
“Justin Post - Bank of America Merrill Lynch
Sundar, could you talk about the cloud, why really get more aggressive now? We've been riding on it for many years, and just wondering why now really ramping up the investment? And how would you characterize the margins or the returns on capital in that business? Why is that interesting for you?
Sundar Pichai - Chief Executive Officer, Google, Inc.
Just on the first one, I would say there are three points of inflection for us, and that's why we are really ramping it up. The first is we've always been doing cloud. It's just that we were consuming it all internally at Google, but as we have grown, really matured in terms of how we handle our data center investments and how we can do this at scale, we have definitely crossed over to the other side where we can thoughtfully serve external customers. So that's the first point of inflection.
The second point of inflection for us is as we've been investing in machine learning and AI for years, but I think we are at an exceptionally interesting tipping point where these technologies are really taking off. And that is very, very applicable to businesses as well, and so thoughtfully doing that externally, we view as a big differentiator we have over others.
And third, is definitely Diane Greene coming in. And I think I wanted to scale our efforts here thoughtfully when it is set up with a great leader who understands this space deeply. And so those are the three main reasons why we are significantly ramping up what we are doing there.”
And all of this is happening against a background of aggressive planned datacenter growth and acquisition of seemingly random clients like Apple and Home Depot. They’ve now planned to acquire Anvato, a video streaming platform that has clients such as Oprah Winfrey Network and Fox Sports.
Google is still unclear about its cloud strategy and is overly dependent on what Diane Greene can or cannot accomplish for their cloud business. They need a lot more direction than that.
Google Apps is the third straight arrow in their quiver, but they’ve lost the No. 3 position there as well, having been ousted by Office 365 racing to the top spot and beating everyone including former No. 1 Salesforce.com.
But the fourth place doesn’t necessarily mean they’ve lost the game. They just need to step harder on the gas to get Google Apps to a higher yield.
The Investment Case: Where are you with GOOG?
So Google does have problems; that much is clear.
For now, I can only recommend a HOLD on Google stock. The variables are too many and the uncertainty factor is high. What I do know is that if their ad revenues do start to take major hits over the next few quarters, it’s time for them to reassess their priorities and re-strategize for the future.
What they need right now is some serious revenue diversification, and I’m not sure anyone knows how they will accomplish that, or when.