Once the dangerous moment is over, everything could be fine… DNY59/iStock via Getty Images
By investing, theLollapalooza Effect” can mean both good and bad things. In this case, I’m going to focus on a series of rising headwinds for Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), which are probably not so obvious to many investors and are causally related to each other. Together, they could become a real headache for the company.
Discuss ChatGPT (MSFT) is not what I intend to do here – I prefer to point out the likely multiple implications of its emergence and try to quantify their financial impacts.
The curse of greatness
First, size becomes an issue for Alphabet. The global advertising market, according to Statesman, was around $800 billion in 2022, of which Alphabet’s $224 billion alone accounted for 28%. While the total pie is likely to grow further at a mid-single-digit CAGR, the days of mind-numbing growth rates are probably over, especially as 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 dominant players, but it won’t reach 100% and its progression will slow from there.
Overall, traditional advertising (TV, print, outdoor, etc.) is unlikely to drop below 30%, as a successful advertising campaign always needs different touchpoints to be successful. So there isn’t much overall share increase available to compensate for numerical share losses. Likely, Alphabet’s ad revenue will grow from here roughly in line with the total ad market, or perhaps a little slower. We certainly won’t see another decade of 18% compound revenue growth.
Moreover, the political debate on the monopoly power of the company is raging, fueled by a FTC exceptionally passionate. This could lead to quite drastic regulatory interventions, which does not explicitly rule out a break.
dominance issues
Alphabet’s dominance in the digital advertising market has been the key to every bullish thesis, but in my view that becomes part of the problem here because the question has to be: what if this dominance becomes a little less obvious?
Unfortunately, at this point any disruptive will likely lead to market share losses for Alphabet.
In fact, it has happened before and has simply been masked by overall market growth. More and more people search for products directly on Amazon (AMZN) who has built a formidable advertising business. Apple is also working on its own advertising business. Finally, thanks to ChatGPT, Bing could come into play again.
We don’t need ChatGPT to build Bing THE dominant search engine (it probably won’t – disruptions usually happen in much more differentiated ways), we just need it to be seen as a place where global brands duty show their presence. (Microsoft is Already working This would not only result in advertising budgets for a competitor (thereby reducing revenue), but would also result in an increase in Alphabet’s R&D budget (thereby reducing profit margins) to counter the threat.
Additionally, Morgan Stanley analyst Brian Nowak noted that if only 10% of searches shifted to language models, due to their higher computational intensity, the operating expense increase for Alphabet would be $1.2 billion. I guess we can all agree that – if language patterns prevail in internet search – their share will be over 10%.
And what about income? Doesn’t more competition normally lead to lower prices? I guess if Microsoft sees a way to make Bing a competitive search engine, it would be open to some pretty aggressive pricing strategies.
Finally, if thanks to ChatGPT, Bing takes a small but significant share of the Internet search market, the infamous ~$15 billion deal with Apple (AAPL) that makes Google the default search engine on iOS could come into play. I’ve always found it extremely interesting to ponder this deal: why would Alphabet sacrifice around 7% of its ad revenue to secure the top spot? , especially since most iOS users would choose Google anyway? The agreement, in my view, highlights how fragile Alphabet considers its ditch to be.
This would confirm my thesis: Google will remain dominant as long as it absolutely dominating. Once small cracks appear, there will be no kind of domination and the beauty of monopoly will disappear forever.
In this context, how much would Alphabet need to bid once Apple actually had one or more different choices or there was a competitive bidder?
“Unnecessary expenses” and “return of capital to shareholders”
I guess most observers would agree that the tech giants have splurged a lot over the past decade and capital allocation hasn’t been very efficient in most cases. Yet the question must be asked how much of this spending is actually a necessary part of the game – ie are we really talking about “unnecessary” spending or more likely “defensive” spending? In other words: When Meta (META) is exploring immersive digital worlds, Apple is exploring four-wheeled computers (i.e. self-driving cars), and Microsoft is funding OpenAI, not all are other competitors strength Do the same thing? Isn’t that the main reason for the large cash reserves often considered excessive on the balance sheets of tech giants? The digital world is changing rapidly, even giant empires can be disrupted in unexpected ways, so they have to be paranoid prepared for anything. Since the FTC won’t let them just buy the next big thing, everything has to be developed in-house.
So what would happen once profit margins shrink? As less money would be available for “other bets”, the moat would become more fragile.
Yet the biggest issue for investors has always been stock-based compensation. As Eric Sprague showed in his recent article, almost all of the FCF generated by Alphabet ended up in the pockets of its employees. The buyouts only sterilized the dilution, and the RSU taxes made it even worse: Overall, $189 billion was spent over the last ten years, which was effectively the money of the shareholders. Most companies characterize buyouts as a “return of capital to shareholders”, but nothing could be further from the truth in this case: Alphabet has in fact taken almost all the profits generated Since shareholders.
Investors have always forgiven this sin simply because the stock has done well until recently. But once the stock is not enough always go up, investors will demand their fair share. This means that less money is available for employee retention and various perks, or dilution will increase, weighing more on the stock.
Valuation implications
In my view, Alphabet’s business will strive or face a profound transformation with unclear results. Its moats are less robust than is generally thought. This makes the business less predictable in the long term and therefore less valuable. In other words, despite a still good near-term growth outlook, markets could apply a lower multiple to the company’s earnings, especially since management has yet to explain how investors can make a profit. performance when all cash benefits accrue to employees.
If R&D and other operating expenses grow 15% or $12 billion from here, net profit margins shrink to 17% from 21% in 2022. (Still a great net profit margin!) Coupled at 7% revenue growth for the next decade, net revenue in 2033 could reach $95 billion, or just over 50% total growth.
Excluding any dilution, that would mean EPS of $7.30. At a multiple of 16x, the stock would be trading at $117 – not exactly a great return compared to today’s $87.
Certainly, this is probably the case with the bear.
At this point, we can easily see why I mentioned capital allocation and stock-based compensation: over the next decade, if all goes according to plan, Alphabet will generate around $700-800 billion. of FCF. Where will this money go? If it really comes down to shareholders, the outstanding shares could easily drop by around 50%, i.e. EPS would not be $7.30 but $14.60. And the multiple would probably be higher as well. So overall, we could be talking about a stock price above $250 in 2033.
But what if a lot of that money is spent on sterilizing dilution, capital-intensive projects, or defensive “other bets”? What if management didn’t exactly have much choice and had to spend more to counter attacks on Alphabet’s moat? There is a wide variety of potential outcomes.
I’m not saying GOOG stocks aren’t cheap here. He probably is quite cheap because Alphabet is starting the battle from a great position and the capital allocation issues are so obvious that the company will have to address them sooner rather than later.
Probably Alphabet will squander a lot less than $700-800 billion of FCF over the next decade, so at least half of that should actually go back to shareholders. With an effective reduction in outstanding shares of 25%, EPS could reach $10 in 2033 and shares could double by then. If earnings grow faster than in my rather bearish scenario, overall the stock could offer even better returns.
Yet this probabilistic assessment is the result of a wide range of potential outcomes. It’s like driving a truck over a fragile bridge: once done, everything is fine. But the bridge could break.