Hey Google, Who Has the Best Capital Allocation in the Internet Sector?
Alphabet Inc.: Brilliant M&A and Smart Capital Return
Bezos, Zuckerberg, or Hastings?
Ask a typical internet investor who the best capital allocators in the space are, and you are very likely to hear about Amazon, Facebook, or Netflix, and perhaps deservedly so.
Amazon CEO Jeff Bezos launched what seemed like a simple online book business in 1994, but through brilliant strategic decision making and investments, he and his team turned the company into a juggernaut that now dominates ecommerce, cloud computing, and increasingly digital advertising and logistics. And plenty more ventures are sure to come.
Facebook CEO Mark Zuckerberg co-founded the ubiquitous social network (or stole the idea, depending on who you ask) in his Harvard dorm room and brilliantly refused to sell despite a $1Bn bid from Yahoo in 2006. He went on to acquire Instagram for a mere $1Bn in 2012 and WhatsApp in 2014 for $19Bn. These acquisitions, a stubbornly long-term vision by Zuckerberg, and nimble decision making have cemented Facebook as the most dominant online social network globally, now gushing over $20Bn of annual free cash flow.
Reed Hastings transitioned Netflix from a simple mail order DVD business to the largest subscription video streaming platform on the planet. A key move he made to achieve this dominance was to convince John Malone’s Starz in 2008 to license its library for four years, tripling Netflix’s content count. How much did Netflix pay to license this critical IP from Malone, arguably the best media investor of the last 50 years? Just $20-30MM. By deftly exploiting linear content providers’ desire for additional profit streams and using an aggressive capital structure despite years of negative free cash flow, Netflix went from the “Albanian army” to, well, Netflix.
Enter Alphabet (Parent Name of Google)
In contrast to Amazon, Facebook, and Netflix, many investors think of Alphabet Inc. as merely a search advertising business that has done the same thing for going on 25 years. In fact, Peter Thiel has launched all manner of self-serving attacks on Alphabet, from nativist claims that it operates on behalf of China to assertions that the company does not innovate.
In reality, the company has expanded well beyond simple search and now plays a dominant role across a variety of verticals, from digital advertising to cloud services to mobile phones to online video. How did the company achieve this dominance? Through a series of brilliant decisions spanning multiple management teams.
A Short Walk Down Memory Lane: AltaVista and Yahoo Ensure Their Own Demise
In the halcyon days of the early commercial internet, search was a highly contested field. Companies like HotBot, AltaVista, Lycos, and many others brawled to be the dominant search engine helping guide users through the wild wild west that was the internet in the mid- to late-90s.
Sergey Brin and Larry Page were grad students at Stanford at the time, and in 1996 they conceived of and built an innovative search engine that used links to determine the importance of individual pages. Based on these links, they prioritized various pages to drive internet search. They initially called the search engine Backrub before changing the name to Google, a play on the number googol, equivalent to 10^100.
Clearly not focused on the venture, Brin and Page offered to sell Google to AltaVista in 1998 for $1MM, hoping to make a quick buck and return to academics. Thankfully for them, AltaVista turned the offer down.
In 2002, Yahoo approached Google seeking to acquire the business, but Yahoo turned down Google’s $5Bn price tag.
Given Alphabet’s $1.4Tn enterprise value today, perhaps AltaVista and Yahoo former management feel more than an ounce of regret.
Over the course of the late 1990s and early 2000s, Google built the infrastructure that would make the company by far the most dominant search engine globally based on its initial search technology of page links. While there was clearly a flywheel effect, whereby good search results would drive more users to Google, which would provide the search engine with more data to further improve results, and therefore drive more users—comprising a virtuous cycle—Google also used brilliant M&A to cement its search dominance.
Alphabet’s Stunningly Accretive Acquisition History
Google has created enormous value from acquisitions, and these acquisitions built on and reinforced the core technology Brin and Page had developed at Stanford. Key acquisitions include YouTube, DoubleClick, AdMob, Android, and Motorola, just to name a few.
YouTube was acquired in 2006 for $1.65Bn in cash and stock. In 2020 alone, YouTube generated over $20Bn in revenue likely at roughly $4Bn or more of EBIT, though the company does not break out YouTube profits specifically. YouTube continues to grow revenue at over 45% YoY, and it is by far the most dominant video platform globally, with over 2Bn monthly active users and over 1Bn hours viewed daily.
Critically, YouTube ties users even more tightly into the Google ecosystem given its dominant position in video on both desktop and mobile, the latter of which accounts for 70%+ of watch time.
And YouTube is now the largest social media platform in the US.
YouTube is also making dramatic inroads within live streaming.
DoubleClick and AdMob comprise the critical desktop and mobile ad serving infrastructure behind Google’s core search business. DoubleClick was acquired in 2007 for $3.1Bn in cash and AdMob in 2008 for $750MM in stock. Google’s dominant ad platform wouldn’t exist as it does today were it not for these two acquisitions.
The AdMob acquisition was equally prescient. As this article at announcement of the deal indicates, mobile advertising was virtually non-existent at the time, but AdMob had a dominant position in mobile display advertising, an area in which Google had no real presence.
Within just a few years, Google was by far the most dominant player in mobile advertising and retains that position today.
Perhaps the company’s “best acquisition ever,” according to VP of Corporate Development David Lawee, was its purchase of Android for an estimated $50MM in 2005. The deal was actually so small that the acquisition price was never announced. This stunningly cheap acquisition gave Google an entree into the mobile phone market in a highly strategic fashion. Android is an open-source mobile operating system. By buying and then enhancing this platform, Google was able to push Android onto the vast majority of mobile phones and ensure default status for various applications, including Google Search, Maps, Gmail, Chrome, and YouTube. Today Android is the most dominant mobile operating system, commanding over 70% global market share.
To help further cement its mobile dominance, Google acquired Motorola Mobility in 2012 for $12.5Bn in cash. This acquisition offered key patents to bolster the Android operating system against competitive threats from Apple’s iOS.
It’s also worth remembering that Google sold the cable set top business to Arris for $2.4Bn and the handset business to Lenovo for $2.9Bn (both these businesses were part of Motorola). Google therefore acquired the Motorola IP it sought to bolster Android for just $7Bn net of these asset sales.
To fund these investments, Google primarily used cash, only issuing its precious equity when sellers like AdMob founder Omar Hamoui and YouTube’s founding trio were smart enough to demand it.
Which leads us to our final subject in this edition of the newsletter: equity shrink.
Google’s Highly Accretive Share Repurchase
By 2015, Google was generating over $25Bn of free cash flow, an amount of cash generation the company simply could not reinvest fast enough. Even with the development of Google Cloud Platform (now the fastest growing and third largest cloud provider globally but then still a nascent moonshot project), cash was piling up. In the low-interest rate environment of the past 10+ years, growing cash piles can burden returns on capital and cause investor concern.
Compounding the heartburn, Google was issuing over $5Bn of annual stock-based compensation to employees. This level of equity-based compensation was beginning to significantly dilute shareholders.
So, after just one year of share repurchase in 2010, Google began a significant share repurchase program in 2015. Looking back, this share repurchase has been wildly accretive. The company has now bought back $69Bn of stock starting in 2015 at a weighted average share price of just over $1,200. Today’s share price of $2,300 puts the repurchase accretion into context. Over the same timeframe, shares of GOOGL have compounded at 22% per year. And as share count has begun declining, remaining shareholders take home more of every dollar of free cash flow generated.
One can easily argue that the accretive acquisitions of the past are ancient history. There is some validity to this point, but management prudently shifted to highly accretive share repurchase when large scale M&A opportunities began to wane, and they began funding Google Cloud Platform, which is now firmly part of the three-player global oligopoly that is cloud computing—an industry growing at a rapid pace with EBIT margins at 30%, extremely low churn, and estimates of IT spend in the cloud as low as 5%, surely to head higher for decades to come.
It should also be noted that the company’s excellent capital allocation track record has been executed under various leaders: founders Brin and Page, former CEO Eric Schmidt, and current CEO Sundar Pichai. This indicates an institutional understanding of excellent capital allocation.
The question going forward, of course, is whether Google’s capital allocation track record can be sustained, especially given current antitrust scrutiny. The latter point needs to be considered and almost certainly has put a damper on strategic acquisitions for some period. But just consider Microsoft, which 20 years ago was fighting an appeal to prevent the company’s breakup, ultimately settling with the DOJ. Today, Microsoft is stronger than ever and on an acquisition spree. If Microsoft is a good precedent in this regard, then Google’s future is brighter than ever.