The Business Of

Eyeballs | Alphabet | What Do They Do With Their Profits?

Morning All!

Yesterday we put together Alphabet’s costs with their revenues. And we’ve covered a fair amount this week. So let’s have a quick recap…

• 80%: ~80% of Alphabet’s revenues come from advertising. The company has seen incredible growth, with revenues going from $3bn (2000) to $307bn (2023)!

• $19bn: One of Alphabet’s largest costs is ‘acquiring traffic’. The company pay Apple an astonishing ~$19bn to be the default search engine on our iPhones!

• 20%: No surprises, the tech giant has boasted strong margins over the years. Gross margin has never gone below 54%. And EBIT margin never below 20%!

And speaking of margin. It is a Thursday morning. Which means it’s time to take a look at our famous TBO EBIT Margin ranking! Below, we can see our ranking updated to include Alphabet. And whilst ~27% is an incredibly impressive margin figure - it means Alphabet doesn’t break into our TBO Top 10!

Now, this may have surprised some of us. It certainly surprised me at first. How does Barclays, McDonald’s and some of the other companies there have a higher margin than Alphabet?!

Well, the answer is in the details. In Alphabet’s 2023 annual report, we can see that their Google Cloud segment has a tiny EBIT margin of only ~5%! And Alphabet’s ‘Other Bets’ division, is also unprofitable! And what does this mean? Well, it means that these 2 segments DRAG DOWN Alphabet’s overall EBIT margin!

So, what does the EBIT margin look like if we just look at Alphabet’s advertising business? Well, it’s around 35-37%… which is considerably better than the ~27% that Alphabet report as a company overall! And 37%… that would get Google’s advertising business into TBO’s Top 5! Alrighty, let’s move on!

Errr What Do Alphabet Need So Much Capex For?!

So, to kick us off, let’s as always look at the waterfall chart below. Which shows us how Alphabet have spent their cash from operations (CFO) since 2004.

As we can see, Alphabet made a huge ~$666 billion in cash from operations from 2004-2023. Which is absolutely massive. The majority of that cash was spent on buying back shares (~$240bn) and capital expenditures (~$230bn). And what’s incredible is that, even after the sizeable buybacks and capex, the tech giant still had an extra $100bn of cash left over that they’ve just added to their balance sheet!

But let’s touch on something interesting here. And that’s capex. Why on Earth is Alphabet’s capex so high? In previous weeks, we’ve seen Tesla, TSMC, and Maersk all spend a big proportion of their cash on capex. But that made sense because all 3 of those companies need increased capacity to grow. Tesla need more warehouse space to build cars. TSMC need more warehouse space to make chips. And Maersk need more ships to carry containers.

So, the question is - what do Alphabet need more space for? Well, the answer is - computers!

Data Centers, Data Centers, and More Data Centers!

Now, what do we mean? ‘Computers’ isn’t exactly the clearest of answers! So, let’s dig a bit deeper! In yesterday’s newsletter, we talked about Alphabet’s data centers. These data centers are basically massive warehouses filled with hundreds of thousands of computers. And these computers store and process all the DATA needed for Alphabet’s services - including Google Search and YouTube.

The image below is a reminder of what these data centers look like on the outside (left) and inside (right).

Now, when Google started out, all they had was a few servers (computers) in a garage. However, as the company grew, and more people used Google Search, the company needed more and more servers. Why? Because as more people searched things on Search, watched things on YouTube, and emailed things on Gmail - what did this mean? Well, it meant Alphabet needed more computers to store and process all this DATA! So, in 2007, Alphabet built their first custom data center in Oregon, USA.

However, the need for computers (and hence data centers) didn’t stop there. More and more people were using the internet and their services. And so, Alphabet continued to expand. By the end of 2012, Alphabet didn’t have just the 1 data center, they had 12 of these huge computer warehouses!

But would you believe it - the capex journey didn’t stop there either. In fact - as the chart below shows us - Alphabet’s capex in 2012 was actually pretty low compared to its current level! From a level of ~$2-3bn a year. Alphabet then started to up their capex quite aggressively, all the way up to ~$32bn last year! And Alphabet now has 24 data centers all over the world!

However, that 24 data center figure only tells us a part of the picture. Sure, Alphabet has grown over the last decade and more and more people are using their services like Google Search, YouTube, etc. This has meant Alphabet have needed more data centers to keep up with the data needs for those services. But there’s 2 more parts to the story…

… and the first part is cloud! Back in 2006, Amazon created AWS - their cloud computing service. And the birth of AWS meant that companies who previously required lots of physical servers/computers (e.g. Alphabet), could now use ‘virtual servers in the cloud’. Now, instead of ditching their physical servers, and using AWS - Alphabet decided on another option. They decided to make their own cloud computing service - called Google Cloud! Since 2008, Google Cloud has grown in popularity and helped some of the biggest companies in the world (HSBC, Twitter) with their data storage and processing needs. And what did this mean for Alphabet? Well, it meant that for the first time, Alphabet didn’t need more computers to power their normal services (Google Search, YouTube, etc)…

… they needed more computing power to store and process all the data for their cloud customers (e.g. HSBC, Twitter)! And so, what did Alphabet do? Well, they needed more computers (servers) and more space to put all these computers! And so, since 2012, Alphabet have been on a spending spree - building more and more physical Google Cloud locations (basically data centers) to help them process and store all their cloud clients’ data! In the chart below, you can see how Alphabet’s Google Cloud locations have grown over the years from just 3 in 2013 to 40 in 2023!

That’s a very brief story on Google Cloud. But I promise, when we look at The Business Of Cloud, later in 2024, we’ll go into much more depth! Okay, let’s move on. We now know that Alphabet’s capex boom is partly down to the increased usage of Alphabet’s own services (Google Search, YouTube, etc). And partly down to the increased usage of Google Cloud. But what’s the third part? Well, the third part is down to everyone’s favourite buzzword right now… AI!

So, how has this AI revolution led to Alphabet spending more of their cash on capex? Well, we’ll be brief. But back in 2015, Alphabet started working on their AI product, Bard - now called Gemini. Now, think about this. The computing power needed to send you millions of search results in Google Search when you make a query is incredibly high. The computing power needed to store and process data for Google Cloud clients is also incredibly high. But imagine the computing power (and AI chips) needed to run large language AI models, like ChatGPT and Gemini. Mind-blowing!

Happy Shareholders, Happy Life!

Alrighty, so that’s capex out the way. Now, let’s turn our attention to the predominant way Alphabet have spent their cash - share buybacks!

Now, whilst Alphabet have pleased shareholders with mammoth share buybacks of late. This wasn’t always the case. In fact, up until 2015, Alphabet didn’t return any cash to their shareholders! There was no dividend. There was no buyback. The company was 100% focused on growth. All the cash Alphabet made was reinvested into growing their revenue/profits.

However, that all changed in 2015 when Alphabet’s CEO, Sundar Pichai, announced that the tech giant was going to start returning cash to shareholders in the form of share buybacks. For those of us who need a little recap on how share buybacks return cash to shareholders - check out this article!

Now, at first, these buybacks were a fairly small proportion of Alphabet’s overall cash use. In 2015, Alphabet made ~$27bn in cash from operations. And only ~7% (~$1.8bn) was spent on buybacks. However, as we can see from the chart below, this has increased massively since then. Last year, Alphabet made ~$102bn in cash from operations. And they spent a whopping ~60% of that on buying back shares! Happy wife shareholders, happy life!

You Don’t Need To Create The Next Nvidia To Be A Successful Entrepreneur!

Okay, let’s wrap up with a brief word on acquisitions. As we saw from the waterfall chart earlier, acquisitions haven’t been a huge use of cash for Alphabet. But this isn’t because Alphabet have stayed away from acquiring companies. Far from it! Since 2000, the tech giant has acquired over 250 companies! Which means Alphabet have made ~10 acquisitions a year.

So, how does this work? Well, it means that Alphabet acquire a lot of companies - but the majority of these companies are fairly small in size! Now, of course, there have been a couple of big acquisitions. One notable success was the video streaming giant - YouTube. And one big failure was Motorola.

But what this means, is that lots of startup entrepreneurs have done incredibly well for themselves by selling their small-ish businesses to Alphabet! And this is something we can forget about business. You don’t have to start the next Tesla, or Nvidia, or be a ‘successful’ entrepreneur. Here’s an article which highlights all the smaller acquisitions Alphabet have made over the years!

29th Feb 2024

Nigel Jacob CFA