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Growth in an uncertain environment


With more than 90% of the search market share in the US and more than half of the world’s population using its search engine, it’s fair to ask where the next growth could come from.

Google is the world’s largest advertising media company, but still has less than a third of the total advertising share in the US, with the digital advertising market accounting for about 68% of the total advertising market. So there is additional market share, but regardless of that parent company, Alphabet is inherently positioned for structural growth.

While many advertising companies work cyclically with a single driver of growth, Alphabet has managed to develop multiple drivers for consistent organic growth. The main search engine remains the primary advertising medium for most companies, and it remains very resilient in today’s more challenging economic environment.

Google Play (Android), understandably, was the reason Steve Jobs resigned from Google’s board, and today is the operating system on nearly three-quarters of the world’s mobile phones, earning commissions on those mobile transactions and payments.

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YouTube, which has more than 2.5 billion users worldwide, has grown revenues comparable to Netflix, while the cost of its content is a fraction of a typical media company. Almost a quarter more teenagers in the US use YouTube than TikTok or Instagram. Despite becoming the third largest in the US, Google Cloud continues to invest heavily in scaling the business for ultimate profitability as another key growth driver. This overall combination clearly shines through when you consider that overall revenue growth has not lagged behind even Apple’s crown jewel (its services division) over the past five and ten years.

Alphabet is one of the lower-quality technology-focused companies with free options for future organic growth drivers. It invests heavily in artificial intelligence, quantum computing, self-driving cars (Waymo) and biotech (Verily Life Sciences). It’s particularly active in healthcare, investing $1.7 billion in forward-thinking healthcare ideas last year alone, ranking it fifth among all companies in the Nature Index (which tracks the success of scientific analysis in the life sciences). It also recently completed the acquisition of Fitbit.

Alphabet deserves special credit for the management culture, the organization of the business for sustainable organic growth.

Tech entrepreneurs typically demand independence and enjoy implementing their business vision while leaving proper corporate governance to a successor. Not so with the alphabet.

Larry Page and Sergey Brin developed a search engine while studying at Stanford University, and in 1998 they offered it to Yahoo for a million dollars. After being rejected, they opened their own business and in 2001 appointed Eric Schmidt as CEO and themselves as presidents. This independent appointment has been key to developing Google’s professional business with a well-balanced board from academic, scientific and creative backgrounds. Critically in terms of financial discipline, they appointed Ruth Porath of Morgan Stanley as CFO. Few tech entrepreneurs are willing to limit their dreams in this way. The formation of Alphabet as a holding company soon after with other stakes as a separate business was evidence of this.

Many equity investors seek strong and sustainable organic growth and find candidates within the digital (or fourth industrial) revolution theme. The challenge is to identify companies that are already very profitable and have strong balance sheets – not the more “airy” type of business that is still capital intensive and requires additional financial support from shareholders.

Alphabet currently has a gross margin of 57% and an operating margin of 31%. Its total ROIC is 21% and increases to 51% on balance sheet cash. It has $140 billion in cash (10% of market cap), allowing it to expand share buyback activity.

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While Alphabet continues to reinvest aggressively and spent more than 12% of sales on research and development last year, it has built a solid track record of generating excess free cash flow — in our view, a key reason to invest in the stock and a key driver. which defines the fundamental value of the business. Alphabet’s free cash flow sometimes takes a big step up and then stabilizes, but it rarely takes a big step back. This clearly favors investors.

The current economic outlook is particularly uncertain, and the overall advertising market may not impress for some time. Alphabet could easily “manage” its bottom line by holding back on investments in, say, Google Cloud, but we don’t think it’s that short-sighted. Regulatory risks have loomed for a long time, essentially as a result of its effectiveness.

With the listing, Alphabet (Google) made it clear that this is no ordinary company – it rather focuses on creativity and the challenges of providing accurate information. Exactly one year before your silver anniversary, there are good reasons to think about non-standard holidays.

Gerrit Smith is a portfolio manager at Stonehage Fleming Investment Management

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