Google: Cracking Monopoly or a Thriving Ecosystem?

Google is depressed from many angles: ChatGPT, Antitrust investigations, employee relations etc... It's getting sold off, what should we do?

I am going to tell you something amazing. Just look at this chart 👇

See the dip in November 2022? This was a huge buying opportunity, yet many people missed it.

Even Bill Ackman started buying after this and now his average cost basis in Google is just below $100.

Now, here is the surprising thing: Google is now cheaper than it was in early 2023, when Ackman started to accumulate. It’s even cheaper than November 2022 dips.

Here is the proof:

Google was trading at 19 times forward earnings in 2022, it’s now trading at 18 times forward earnings.

This indeed indicates relative undervaluation in Google. But is it a buy?

Google has much negativity going on lately:

• Failed Wiz acquisition.

• Ongoing antitrust cases.

• Malfunctioning AI products.

Question is simple: Are those fundamental problems that are breaking the business economics or just speed bumps on the way?

I warn you, this is going to be one of the most interconnected deep dives you have ever seen.

So, let’s cut the BS and get started.

What are you going to read:

1. Understanding The Business

2. Moat Analysis

3. Investment Thesis

4. Fundamental Analysis

5. Valuation

6. Bonus: Antitrust Issues Evaluated

7. Conclusion

---

🏭 Understanding the Business

If you have ever started a business or even tried it, you know this: The first thing you do is registering a domain name.

Google was no different. It started by registering the domain name “Google.com” in 1997.

Its founders had met by luck.

In summer of 1995, Larry Page got accepted to Stanford University PHD program in Computer Science. Before the term started, he attended a campus tour for admitted students. His tour guide was nobody but Sergey Brin.

They became friends pretty fast.

The idea of creating a search engine actually came up as a research question in Larry Page’s phd studies.

He was entangled with the problem of mapping the world wide web. His supervisor, Terry Winograd, encouraged him to pursue the idea. Later, Sergey also attended Page’s research group.

They came up with the idea that backlinks, links that redirect users to another website, were particularly helpful in determining how useful the web page was.

Together, the pair authored a research paper titled "The Anatomy of a Large-Scale Hypertextual Web Search Engine", which became one of the most downloaded scientific documents in the history of the Internet at the time.

They first created the project called “Backrub” which was basically a web crawler that gathered backlink data.

It didn’t take long for them to realize that the data gathered by the crawler could be used to create a search engine. They developed an algorithm that relied on a new technology that analyzed the relevance of the backlinks that connected one web page to another.

This is how “Google” as we know it was born. This is the first Google doodle from 1998:

This is the story of “the search engine”, the bedrock of Google’s business.

It launched AdWords in 2000 and monetized its search engine.

Google Ads raked in $70 Million in the first year. It wasn’t perfect. But they continuously made improvements:

• Experiments with the layout

• First advertisers were manually contracted, later they added self-signup.

• Experiments with the bidding system - at first a company could buy all three spots of a single keyword.

Ads still remains as the core revenue source of the company.

One thing they knew that their business, ads, was an eyeball business. Overtime, they acquired other businesses that had significant potential to attract even more eyeballs to Google’s ecosystem:

• Youtube and Android were acquired in 2005.

• DoubleClick was acquired in 2007.

• Motorola Mobility was acquired in 2012.

These businesses allowed Google to scale advertising within an ecosystem.

Youtube is currently not just a video streaming service but it’s also the second largest search engine in the world, after Google itself.

Acquisition of Android and HTC allowed Google to monopolize the smartphone operating system business given that Apple doesn’t license IOS. This allowed Google to earn not just licensing fees but also gather critical data to enhance its advertising business.

Only big non-adjacent business venture of Google so far is its cloud business created in 2008, which is growing very fast currently.

It also generates some revenue from Google services like Google Play.

Overall, we can say that Google remains an eyeball business with the exception of services and cloud. Reflecting this structure, Google reports revenue primarily under three categories:

• Google Advertising, (search, adsense and Youtube)

• Google Subscriptions, Platforms, and Devices

• Google Cloud

It also reports small revenue for other bets that come from projects that Google invested in, but it’s best to totally ignore this revenue as it’s so small.

Now that we have a grasp on the business, let’s see how strong the business is.

---

🏰Moat Analysis

First things first: Google has one of the strongest moats that history has ever seen.

However, to understand why this moat is exceptionally strong, we have to first understand the market characteristics that give rise to this unique kind of moat.

Google is a digital business. It operates in digital markets, not in traditional markets.

This breeds a consequential distinction: Market characteristics are completely different.

The primary competitive paradigm in the traditional markets is price. Think about commoditized products like rice. Best rice is the cheapest rice.

Price is just an element in digital markets, it’s not that decisive. Take the iPhone for example, it’s way more expensive than the peers but people pay because it has superior qualities.

Digital markets are characterized by:

• fast-moving nature

• two- or multi-sidedness

• non-monetary-price nature

• network effects

• multi-homing

• data accumulation

• large fixed costs

• small variable costs

Especially four of these characteristics,

• network effects,

• large fixed costs,

• data accumulation,

• small variable costs,

when come together, create a phenomena that is common in digital markets: Market tipping.

The definition refers to the phenomena that once a company reaches a significant market share, its growth accelerates until it wins all or most of the market.

Why does this happen?

It happens because when the business has large fixed costs and very little variable costs, it can offer too much value for too little cost to the potential customers. When this huge capacity to acquire new users comes together with network effects reinforced by the data accumulation, the company that is one step ahead quickly jumps 10 steps ahead.

Network effects and data accumulation are already strong moats, however, the winning company can go beyond that.

The Winning company can create complimentary services or pick the winners in complementary markets.

This way it creates an ecosystem that is really hard to leave. Ecosystems have superior business economics:

As the business scales, marginal cost decreases while marginal value increases. This is how tech behemoths are made.

Google is one of those huge ecosystems that is nearly impossible to penetrate into.

Simply thinking this massive ecosystem can be broken by ChatGPT, while Google is also not a starter in AI, is naive.

Search is most vulnerable to threats from agents like ChatGPT but I don’t think it will lose to ChatGPT like agents in the short and medium term.

Google’s search doesn’t benefit from simple network effects. It’s a three sided ecosystem involving users, advertisers, and creators. Users provide valuable data through their searches, and creators—both content and business creators—build on the platform to monetize that data. Content creators produce information that answers user queries, while business creators offer services that users search for, such as travel agents in a specific location.

Google uses the massive data flow from these interactions to identify gaps in the market and create new products, like Google Maps and Chrome. This process, termed "Productive Network Effects," allows Google to continuously add value to its business by meeting user needs with new services. This, again, reinforces the ecosystem.

You can’t just replace such a powerful ecosystem by what is most suitable to be a personal productivity assistant. Market share data proves the point:

ChatGPT and the like may be many things. But they just can’t disrupt such an intricate ecosystem while the ecosystem giant itself is developing a comparable product that is not that behind.

Google’s moat is as strong as ever and it won’t be disrupted anytime soon.

---

📝Investment Thesis

My Google investment thesis relies on three pillars:

• Its moat is very strong so the search business is not going anywhere soon. This business has a massive pricing power and can easily drive 7%-8% average annual revenue growth in the next 10 years.

• Youtube is growing revenue at 21%. I think this is not going to skyrocket but Youtube can easily maintain 15% annual growth rate for 8-10 more years as it’s also breaking into sports and becoming a wholesale alternative to TV.

• Google cloud is the fastest growing cloud service among the big three. It currently has 11% market share. As the market is expected to reach $2.3 trillion by 2032, this is going to be a giant revenue stream for Google even if it gains only a tiny market share.

These create a very favorable investment outlook for Google.

---

📊Fundamental Analysis

➡️Business Performance

Well, what can you say?

We see the amazing business fundamentals of Google at work.

Google grew revenue at a staggering 15% in the last 5 years. We are not talking about just a large corporation here. In 2019, Google was already one of the most valuable companies in the world.

When you look at the EPS you see even more impressive results as you see Google’s operating leverage at play. Google nearly tripled net earnings per share in the same period on just doubling revenue. This is because of the huge operating leverage it benefits from. The source of this operating leverage is the high fixed and very low variable costs we mentioned above.

Overall, I just need one word to describe Google’s business performance: Flawless.

➡️Financial Position

Google has no problem with the financial positioning. It’s rock solid.

As you see, Google’s pool of cash and short term investments is nearly four times as big as its debt. Debt has never climbed above 50% of its cash reserves in the last 5 years. This is just enough.

Plus, Google generated $101 billion EBIT in the last twelve months, meaning a quarter of EBIT is enough to pay all the debt.

Google is built to weather all and any financial storms very easily.

The thing you should be wary of is how it allocates the immense amount of cash it’s generating. Let’s take a look.

➡️Profitability & Capital Allocation

• Gross Margin

Google expanded gross margin from 55.6% to 57.6% in the last five years.

This may not be a big change but the message we should get from here is different.

Google, despite all the fuss around ChatGPT and AI, doesn’t feel any competitive pressure to cut prices. To the contrary, it’s raising its prices and adjusting its own gross profit margin itself with the sole consideration of optimizing the return.

This indicates an enormously strong competitive position and I am loving it!

• Profit Margin

Google’s net profit margin expanded from 21.2% in 2019 to 26.7% today.

What does this tell you?

Reading it together with the expanding gross margin, we can say that Google is exerting more and more operating leverage.

You are looking at a dream picture right now: Growing revenue with expanding gross margin and increasing operating leverage.

This is a recipe for exploding earnings.

• Return on Equity (ROE)

This is where I get most excited.

In the last 5 years, Google’s lowest ROE was 18% and highest was 32%.

Given that we are looking at a business that uses little debt and makes investments primarily from its equity pool, this is a very good indicator of its mastery in capital allocation.

Remember, the average of all the American companies is 12% and this has been enough to drive 10% long term annualized growth in the stock prices. Imagine what you can expect with a median ROE that is more than double of the average…

---

Rest of the analysis is proprietary to paid members.

There is a special 30% discount for launch and it ends tonight!

Paid subscribers will also get free access to the email course starting next week.

Click the link below to claim it and support the publication👇

---

📈Valuation

This is where things get juicy.