Google

A Steady 6-10% Compounder with Moonshot Upside

TLDR

Growth in Google’s core search ad business is likely to be anemic, but one of its moonshots (likely Waymo) could pay off.

The Thesis

Google needs no introduction. Over 3B people use its search engine each month.

As ChatGPT has soared in popularity (about 2-300M weekly users) many investors have been wondering if Google’s search dominance is finally ending.

Google was earlier to AI than any of the other large tech companies in the US. This is from their 2016 Founder Letter –

Sergey and I are working well together on the overall Alphabet direction and providing guidance to the companies. Sundar is doing great as Google CEO. It’s certainly a big job and we are very lucky to have him. He’ll probably write this letter again in the future as he has in the past, so I won’t speak too much for him on the Google related topics in this one. But, I’m excited about how he is leading the company with a focus on machine learning and AI. We took a big step in that direction with the Google Assistant, and built it into a new family of hardware devices like the Pixel and Google Home. There’s a lot more to come.

Despite their early lead it was OpenAI that took the world by storm with ChatGPT in November 2022. The subsequent explosion in ‘answer engines’ is bringing Google’s whole advertising model into question. Why deal with pesky ads when you’re searching for something on the internet, when you get just get an answer?

These concerns have put a damper on Google’s stock price performance. The stock is up about 36% in the last three years vs 90% for Meta, which is its closest competitor.

Google search is 56% of Google’s revenue and its highest margin business. They don’t disclose the profits from Google search alone, but its margins have to be meaningfully higher than YouTube where they share 70% of the ad revenue with content creators. My sense is that Google.com is responsible for about 70% of Google’s profits.

Any slowdown in this business would obviously be bad. There are two key metrics that matter for Google’s search business -

1. The Number of Paid Clicks

2. The Cost per Click (essentially how much an advertiser pays Google when a consumer clicks on an ad)

Prior to 2022, the number of paid clicks was consistently growing at high double digit rates. It averaged 35% growth per year between 2013-2021. In 2023, growth was 7% and this year it was down to 4% in the most recent quarter. This is a meaningful slowdown.

Now here’s where it gets interesting. Pre 2022, the CPC typically declined each year. Between 2013-2021, CPC fell 10% per year on average. In isolation this would be bad, but because the number of clicks was growing faster than CPC was falling, Google’s search revenue still grew at 19% a year on average between 2013-2021. Since 2022, Google has found a way to increase CPC. It was up 1% in 2023 and 8% in the most recent quarter. As a result, Google search revenue is still growing, but much more slowly. 8% in 2023 and likely 11% this year.

See rows 66 and 67 of the sheet for paid click and CPC data as well as select financials.

This feels like a mature business and one that is potentially in decline. Even though ChatGPT has about 300m users today, my sense is that their growth as a stand alone app will plateau. Most people already have a habit around Google and aren’t going to switch unless they’re forced to or a meaningfully better product comes along. However, Apple has now begun to integrate ChatGPT into Siri, so Google could see a decline in traffic from their highest value customers as people get answers from Siri instead of having to use Google. This feels like the single biggest risk to Google.

Android users will obviously still get answers from Google, and Android is 70% of the global phone market. Unfortunately, among more affluent shoppers (which most advertisers prefer), the iPhone dominates. In the US, the iPhone has close to 60% market share.

I think Google core business is now mature and will grow at about 5-10% a year at best. I could obviously be wrong. Maybe Gemini drives more engagement on Google and advertisers pay more per click, so growth is closer to 10% than 5%.

In my base case, I see Google’s core services business (advertising plus subscriptions), growing operating income by 7% a year for the next five years. This would imply about $140B in net income in five years. Put a 20x multiple on that (its clearly proved to be sticky), and you get a business worth $2.8T. My sense is Google’s cloud business will begin to approach $100B in revenue by 2028. Assuming a 30% operating margin (same as AWS), you could justify a $1T valuation for that business. Put all this together and Google is worth almost $4T in five years. That’s about 10% a year compounded for the next five years.

What could go better than expected?

1. Waymo. There are about 7m Uber drivers in the US. Assuming half of those are part time, the real number is closer to 3m. If Waymo can replace 1m of those drivers and capture their take home earnings (about $30k on average), Waymo would be bringing in $40B in revenue. This is because Uber has a 30% take rate on mobility, which would now accrue to Google. The margins for this business should be quite good given all the upfront tech investment is now covered, so I would expect $20B in net income is not out of the question. Put a 25x on that and Waymo could easily be worth $500B. Tesla is worth $1.3T today based almost entirely on the promise of FSD. Waymo already operates a service, so this should be worth at least half of Tesla. The wild card here is Google’s ability to execute. They need to get Waymo rolled out across the country before competitors like Tesla catch up.

2. Ad revenue could grow at 10% a year because Google knows more about its users than ChatGPT or any other competitor (outside Meta) ever will, so advertiser’s willingness to pay goes up over time even though number of clicks stays flat or declines.

3. They have further breakthroughs on chips or quantum computing. Its possible Google’s chips are not that different from NVIDIAs for AI workloads. This most likely just translates into increased usage of Google’s cloud, so it may not be that meaningful.

4. Google’s operating margins continue to improve as more of the ad revenue is from their own properties meaning they spend less on TAC. EBIT margins have improved by about 5% in the last 10 years as they have gotten more disciplined on costs. They could also stop paying Apple $20B a year to be the default search engine on the iPhone, and if there’s no real change in usage, that $20B would go straight to Google’s bottom line.

What are the risks?

1. The Justice Department has proposed breaking up Google. Even if none of the ‘remedies’ to their monopoly status come to pass, this could still be a distraction for senior management.

2. People under 16 are increasingly using ChatGPT and many have never used Google. Its possible that in 5 years the whole paradigm for search has changed and Google’s ad business has declined by 50%. I think this is unlikely because old habits die hard, but things can change quickly in the consumer tech space. Just look at PayPal.

Notes

Doing the research for this article just makes me more bullish on Meta. They are growing ad ‘impressions’ (their version of clicks) 50% faster than Google and their Cost per Impression is also growing 50% faster than Google’s CPC. Both companies trade at about 22x next years earnings and AI is more a tailwind for Meta than a threat as it is for Google. It seems unlikely that Instagram or Facebook will just disappear in ten years in the way that Google’s search business could.