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Summary

  • Traffic Acquisition Cost (TAC) is one of Google's most significant and least predictable costs.
  • Overall TAC has been stable, but TAC related to distribution arrangements should increase in the face of rising competition.
  • Facebook has no TAC because its members come to the site of their own volition.

On the surface, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) is a company that "does no evil" and allows great freedom to its engineers and developers to pursue side projects.

Below the surface of this great American story, the picture is slightly different. My view is that its main business, its search advertising business, is its only significant business line when it comes to the bottom line, and Facebook's (NASDAQ:FB) is simply better. Unlike Google, Facebook doesn't have a line item in its Income Statement that is unpredictable and offsets about a fourth of its revenue each quarter: Traffic Acquisition Cost, or TAC.

Overview of TAC

Many investors simply ignore the business models of companies like these and buy the brands instead, but let's avoid that investing faux pas and get a bit more granular on how these rivals make money.

TAC is what Google pays to direct traffic to its site, whether that be through YouTube stars or agreements with other companies. Investopedia defines it as "[p]ayments made by Internet search companies to affiliates and online firms that direct consumer and business traffic to their websites".

For example, Mozilla Firefox is paid $300 million per year to simply default to Google's search engine in its web browser. If I told one of those same uninformed investors that Google does this, many of them would be flabbergasted.

Google's TAC has been stable over the past three years at +/- 1% of 25% of Google's advertising revenue. To put that in perspective, the figure was $12.3 billion in 2013. Source: Google's most recent 10-K.

The expense figure is split into two categories in Google's 10-K: AdSense arrangements and distribution arrangements. Distribution arrangements are the key growth driver in overall TAC spend; TAC related to distribution arrangements doubled from 2011 to 2013.

To me, the split between TAC related to AdSense and TAC related to distribution arrangements is key. AdSense payments are systematic, consistent, and grow slower than Google's revenue, but TAC related to distribution arrangements is growing fast and much more interesting. The example I mentioned above of Google paying Firefox for default search rights is a perfect example of TAC related to distribution arrangements.

TAC related to distribution arrangements is essentially the purchase of dominance, or in other words, monopoly arrangements with competitors. Google pays off a variety of competitors to keep its place at #1. Search is a natural monopoly, i.e. people tend to search on the site with the best results and Google's dominant position gives it the information to find its customers the best results, and Google does not want to give up that position. TAC related to distribution arrangements is hence the more pertinent of the two relative to Google versus Facebook.

How TAC Could Become Problematic for Google

From 2011 to 2013, there was little in terms of major competition to Google's core search business and TAC related to distribution arrangements still doubled.

Fast forward to June 2014 and competition has increased quite a bit. Prior to mobile, there was little competition for Google.

Now that mobile has become such a dominant force in search and the main growth driver in the space, the tables have turned. Facebook is driving a wedge in the mobile advertising pie; according to eMarketer, Facebook will increase its 2013 mobile market share from 17.5% to 21.7% in 2014, while Google's share will fall from 49.3% to 46.8% in 2014.

Google must fight to uphold its dominance in mobile search. That fight will cost money, specifically TAC related to distribution arrangements. A true threat to Google's advertising dominance has not appeared in a long time, and Google will fight aggressively to contain any perceived long-term threats. That will show up in the Income Statement in TAC from agreements like that of Google's with Mozilla Firefox.

The cost of losing its seat at #1, even if just in mobile, is high. If the firm ever theoretically loses its leading position, then consequently, another company has better mobile advertising data than them and therefore better knowledge of what consumers want.

Google's search business is strong and continues to grow its profits at a strong pace, but its other unprofitable businesses have led to lower margins for the Company as a whole.

Because of this, cost control will continue to be a pressing theme for Google management. Search is the goose that lays the golden eggs that subsidizes the Company's spurious R&D. Cost control alongside a large, uncontrollable expense base could be difficult for management to handle.

In a scenario where TAC spend dominates management thinking, the culture that makes Google so great could come under siege as side projects are pushed to the side. From this viewpoint, TAC creates a large number of risks for Google's future.

Conclusion

Google has a weaker business model than Facebook due to Traffic Acquisition Costs. I find that older analysts tend to look down on Facebook simply because it's a social network, but the advantages of its business model, even in comparison to a stalwart like Google, are impressive.

Just like search engines, social networks are natural monopolies. Newcomers flock to the dominant player because the service is better... because newcomers years previously made the exact same choice because the service was better. Both companies control natural monopolies and use them to display ads, but Facebook doesn't have a large cost like TAC that could rear its ugly head in any future quarterly release.

I suggest a trade long $1 FB for every $0.60 of GOOG. This captures the massive growth in the mobile advertising space while keeping the downside risks of owning high-performing technology stocks in control. It also provides a hedge for the growing competition in mobile advertising.

Source: Why Facebook Has A Better Business Model Than Google: No Traffic Acquisition Costs