Google, the leading subsidiary of Alphabet (GOOG, Financial)(GOOGL, Financial), is the second-largest company in the world in terms of market capitalization, and it's just a stone’s throw away from Apple (AAPL, Financial), the current leader. There isn’t much to complain about a company that’s capable of growing its annual sales from $10.6 billion to $75 billion in 10 years.
But the problem with Google is that its revenue streams are skewed disproportionately toward advertising revenues driven by search. Once you take that out of the equation, you’re left with Android and YouTube. These are the only three notable success stories from Alphabet, for all practical purposes, and Android and YouTube are where its attention should be now because these are the only two products capable of providing some thrust to its hunt for revenue diversification.
The Android movement
Android is the clear leader in mobile operating systems, and iOS currently holds second place. Nearly every other OS has been pushed out of the limelight by these two, and it will be hard for any company – even one with deep pockets – to break into their duopoly.
Microsoft (MSFT, Financial) is trying to gain some traction with Windows 10 Mobile by positioning it as a cross-platform OS, but it’ll be years before it can gain any sort of significant market share. For now, it’s just Android and iOS at the top.
Source: IDC
The only problem here is that Alphabet doesn’t make money directly through Android, other than what it makes through app sales. Even that number is not significant enough to be provided on a stand-alone basis. Then why did Google go to such lengths to build Android into the behemoth it is today? The indirect benefit of being a major player in Android does help the company get into as many people’s hands as possible, and by being the most used mobile operating system in the world, it can ensure that Google becomes the de facto search engine of choice. The higher the usage, the more the indirect revenue from advertising.
As you can see, even though Google Play is 50% bigger by downloads when compared to the iOS App Store, it is only half as big where revenues are concerned. Unfortunately, the actual numbers are a closely guarded secret, but the fact that stand-alone figures aren't reported shows that they're not significant enough in comparison with Google’s overall revenues.
Nevertheless, Google continues to build extensive apps for smart devices – Google Maps, Drive, Apps for Work and so on – in order to put the brand in front of everyone as often as possible – just so they can be directed to search, the company’s main revenue channel.
Thanks to Android not being tied to a particular device, it has opened up a huge market for smartphone makers who don’t have the resources to develop their own operating systems – not to mention the apps that really make the OS worth using in the first place.
Several mobile OS companies have been hit hard by the Android storm that followed its launch in 2008, but Apple was able to hold its own because it caters to a more exclusive market. With no other competition in sight, Android is now pushing iOS to its rightful place in a niche segment while continuing its war path of growth.
"According to the latest market share numbers for the first quarter of 2016 (from Kantar Worldpanel ComTech) Android grew significantly in the U.S., Europe and China as Apple’s iOS lost ground.
"In the top five European markets (U.K., France, Germany, Italy and Spain), Android’s market share increased to 75.6%, up 7.1% compared to the same period a year ago.
"Android grabbed 65.5% in the U.S, up 7.3% from the previous year. And in major Chinese urban areas, Android phones had 77% market share, up 6% from a year ago."Â –Â Venturebeat
According to App Annie, an app tracker, downloads on Google Play are expected to triple by 2020 – around the time when the global app market is expected to breach the $100 billion barrier. Though that’s still a few years away, revenue from Android will continue to grow, giving Google some breathing space to figure out the future of its revenue channels.
Other growth drivers of the future
Google is trying its best to keep growing YouTube as a possible long-term fountain of revenue, but the competition gets crazier by the day. So far, it's been the king of free streaming videos, but it's realized that this isn’t enough. That’s why it's going after the paid streaming market with YouTube Red, a direct competitor to Netflix (NFLX, Financial), Amazon (AMZN, Financial) Prime Video and HBO Now. YouTube – the free version – continues to show healthy viewership and ad revenue growth, but it will take years for Red to reach the scale of even Prime Video.
Google Cloud Platform is also something on which it needs to focus. It's already far behind Amazon, IBM (IBM, Financial) and Microsoft in the cloud infrastructure game, and its only monetized SaaS application is Google Apps, which has already been overshadowed by the success of Microsoft's Office 365.
Google Fiber is yet another project that’s showing a lot of promise. Again, the aim is to increase search engine usage. Imagine what will happen if Internet speeds in our homes go up by a factor of 10. Not only will search volumes increase, but the need for search engines themselves will grow – and Google wants to be right in the middle of that. It will further help its ad revenue segment keep its dominant position along with that of Facebook (FB, Financial).
There are a few other projects gaining traction, such as Chromebooks, for example, but nothing significant enough to support Alphabet’s future.
Threats to Google’s business
And that brings us to the biggest external threat that Google faces today. Facebook’s platform is far more appealing because it has the social element that Google does not. By integrating Instagram into its own ad offering, Facebook is attracting even more publishers to its fold. The ad publishing pool is finite, and therefore limited. Google cannot afford to be one-upped by Facebook. And with WhatsApp still sitting outside Facebook’s monetization master plan, things can only get worse for Google.
Today, the bulk of Google’s efforts are directed toward increasing its search visitor volume; that’s because it is what keeps the fire burning. With increasing threats to that part of its business, Alphabet needs to double down on initiatives such as Google Play, cloud offerings and YouTube (including Red). It is the only way it can stabilize its massive ship in what could quickly become a violent ocean.
The investment angle
I’m not trying to paint a bleak picture for Google, but the market does recognize the weaknesses I’ve highlighted. How else would you account for a revenue miss of $120 million ($20.26 billion posted for the quarter against estimates of $20.38 billion) leading to a market cap loss of 5% plus?
With its second quarter earnings coming out this month, we’ll have the chance to see if those misses can still lead to investment opportunities for those that are long Google. At this point, I would suggest a HOLD because there are still a few unknown factors – unrealized opportunities – in Alphabet’s future that need to shape up in coming quarters before it can be a strong BUY.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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