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Alphabet’s Underappreciated Growth Drivers

September 26, 2022

By Gerrit Smit

Many young people do not know of a world without Google and perceive it to be a mature business. With an over 90% search market share in the US and over half of the world’s population using its search engine, the question can rightly be asked where further growth can come from.

Google is the world’s largest advertising media company, but still has less than a third of the overall advertising share in the US, with the digital advertising market making up about 68% of the total advertising market. There is therefore further market share for the taking, but irrespective of this, parent company Alphabet is inherently positioned for structural growth.

Gerrit Smit, is head of equity and portfolio manager at Stonehage Fleming Investment Management — **Gerrit Smit, head of equity and portfolio manager at Stonehage Fleming Investment Management**

While many advertising companies are cyclical with a single growth driver, Alphabet has succeeded in developing multiple drivers for continuing organic growth. The core search engine remains the primary advertising medium for most businesses and it remains exceptionally resilient under the current more difficult economic circumstances. Google Play (Android) was understandably the reason why Apple’s late co-founder Steve Jobs resigned from Google’s board, and is today the operating system used on almost three quarters of the world’s mobile phones, earning it commissions on those mobile transactions and settlements.

YouTube, with more than 2.5 billion users worldwide, has grown its revenue comparable to Netflix’s

YouTube, with more than 2.5 billion users worldwide, has grown its revenue comparable to Netflix’s, while the cost of its content is a fraction of a normal media company’s. Almost a quarter more US teens use YouTube than either TikTok or Instagram. While Google Cloud has grown into the US’s third largest cloud services company, it still invests heavily, scaling the business for eventual profitability as another major growth driver. This overall combination clearly shines through if one considers that its overall revenue growth has kept pace even with Apple’s “crown jewel” (its services division) over both the past five- and 10-year periods.

Alphabet is one of the scarcer quality technology-driven companies with free options on further future organic growth drivers. It invests heavily in artificial intelligence, quantum computing, self-driving cars (Waymo) and biotechnology (Verily Life Sciences). It is particularly active in healthcare, having last year alone invested US$1.7-billion in visionary healthcare ideas, earning it fifth position of all companies in the Nature index (which tracks the success of scientific analysis in life sciences). It recently also completed the acquisition of Fitbit.

Alphabet deserves particular credit for its management culture, organising the business for sustainable organic growth.

Not so with Alphabet

Tech entrepreneurs usually demand independence and enjoy implementing their vision for the business, leaving proper corporate governance for successors to pick up. Not so with the Alphabet.

Larry Page and Sergey Brin developed the search engine while studying at Stanford University, and in 1998 offered it to Yahoo for $1-million. After being turned down, they started their own business and in 2001 appointed Eric Schmidt as CEO, with them as presidents. This independent appointment was key to developing Google’s professional business, with a well-balanced board from academic, scientific and creative fields.

Critically, in terms of financial disciplines, they appointed Ruth Porat from Morgan Stanley as chief financial officer. Few technology entrepreneurs are willing to limit their dreams in this way. The formation of Alphabet as an overall holding company soon afterwards with Other Bets as a separate business was testimony to this.

Many equity investors seek strong and sustainable organic growth and find candidates under the theme of the digital revolution. The challenge is to identify companies that are already very profitable and have strong balance sheets – not the more “moonshot” type of businesses that are still capital intensive and need further shareholder financial support.

Alphabet has a gross margin of 57% and an operating margin of 31%. Its overall return on capital invested is 21%, and rises to 51% excluding the cash on the balance sheet. It has $140-billion in cash (10% of its market capitalisation), allowing for enhanced share buyback activity.

While Alphabet keeps reinvesting actively and last year spent over 12% of sales on research and development, it has built a strong record of generating excess free cash flow – in our view the main reason for investing in a stock, and the main determinant of the fundamental value of a business. Alphabet’s free cash flow sometimes takes a large step upwards and then stabilises, but seldom takes a large step backwards. This clearly is of comfort to investors.

The current economic outlook is particularly uncertain, and the overall advertising market may not impress for a while. Although Alphabet can easily “manage” its financial results by holding back investment in, say, Google Cloud, it is not so short-sighted. Regulatory risks have been looming for a long time, in essence resulting from the company’s effectiveness.

At the listing, Alphabet (Google) made it clear that it is not a conventional company. With its silver jubilee exactly a year away it has good reason to start thinking about unconventional celebrations.

Gerrit Smit, is head of equity and portfolio manager at Stonehage Fleming Investment Management

Kelechi Deca

Kelechi Deca has over two decades of media experience, he has traveled to over 77 countries reporting on multilateral development institutions, international business, trade, travels, culture, and diplomacy. He is also a petrol head with in-depth knowledge of automobiles and the auto industry

Is the Covid-19 e-commerce boom here to stay? By GERRIT SMIT

August 19, 2020

The Covid-19 pandemic has accelerated the adoption of e-commerce in a way no company could have imagined. In fact, in many instances, it has brought three- to five-year sales projections forward in just a matter of months. Many businesses are already living in the future. A good example is Amazon.com, which has experienced record levels of demand, comparable to a usual Christmas period. Not only has its online retail operation thrived, but its video and Web services have also flourished during the lockdown periods around the world.

***Gerrit Smit, head of equity management UK at Stonehage Fleming***

Then there are digital payment companies such as PayPal, which has recorded a remarkable increase in transactions across its network. It took on 7.4m new customers in April alone — a 135% increase. Those new customers are doing more transactions than ever and the business is experiencing retention rates to match.

This must be one of the biggest economic shifts in the world for a long time, if not ever. Nor is this trend likely to reverse materially…Visa, too, is benefitting. Quite apart from an increase in online purchases, hygiene-conscious consumers’ reluctance to touch cash has further boosted business. This is a game-changer for all payment companies whose biggest competitor is cash.

E-commerce is perhaps the most striking example of structural shifts in the economy. Since the beginning of Covid-19 alone, e-commerce penetration as a percentage of retail sales in the US has increased in a matter of three months as much as it previously took a decade to achieve. This must be one of the biggest economic shifts in the world for a long time, if not ever. Nor is this trend likely to reverse materially once economies have fully opened and the virus has receded.

Economic shift

With millions of people working and learning from home, consumers have been forced to rely on e-commerce, and have come to understand the benefits of obtaining goods and services through the Internet. These include variety, safety, convenience and certain cost savings.

From an investor’s perspective, the economic shift to online is revitalising important investment opportunities. In addition to large retailers like Amazon and payment systems like PayPal and Visa, technology companies that enable working from home have also benefited. Consider 5G network providers, data and voice providers, cloud services, data handling and office automation services. More time at home has also meant more home cooking, to the benefit of many food and spices companies, as well as an increase in home design and décor products and services as people adapt their homes for new requirements.

Entertainment and streaming services have also benefited from people spending more time at home, as have online exercise offerings. And of course, this has translated into an increased interest in leisure and sports clothing lines.Investors will find no shortage of newly energised investment opportunities. High uncertainty and market volatility, however, will remain a challenge. Good stock selection is as critical as it has ever been. Investors should be very selective with their investments – buying only quality businesses with strong balance sheets.

Gerrit Smit is head of equity management UK at Stonehage Fleming. He manages the Stonehage Fleming Global Best Ideas Equity Fund