Google: The Pie In The Sky

| About: Alphabet Inc. (GOOG)


Consensus opinion gives Google very little credit for its competitiveness in the cloud.

Google's cloud chief, Urs Hölzle, thinks cloud revenue at Google could surpass advertising revenue by 2020.

Google is now ready to roll its services out in a serious way - the earnings call signals as much.

Expect 2016 to be Google's year of the cloud.

First, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) bought Diane Greene and her company - she is a big deal in the cloud world. Now, on its earnings call, the company spent significant time discussing cloud and explaining it a little bit more clearly for shareholders and analysts.

Cloud is not a new thing of course. Alphabet is however much better positioned to be a big player in this future than it is given credit for by the market. The consensus opinion remains that Amazon (NASDAQ:AMZN) is the king, with its AWS, and Alphabet, being late to the party, may miss out.

Alphabet isn't doing much to try and quash this story by heavily advertising its cloud facilities or combating it. Yet, according to Urs Hölzle, Google's infrastructure guy and writer of The Datacenter as a computer, it is the goal with cloud revenue to surpass advertising revenue by 2020.

Now, that may be optimistic but I haven't factored in anywhere near that kind of growth from Alphabet's cloud services. From what I've seen (a limited sample) nor do most analyst reports, buy or sell side.

Before you pick up the phone and frantically instruct your broker to snap up some Alphabet shares; doubling revenue sounds a little better than it really is.

Very crafty, Alphabet publicly committed to something of a cost + model on pricing. This fits in perfectly with their philosophy to have their businesses scale seamlessly and try to only engineer. It saves on an army of salespeople and account managers. If you implement a model that perfectly passes on cost savings, customized on the actual resources used by customers, there is no need to deal with customized contracts, etc. Clients are automatically served with the lowest cost option. This includes per minute billing and sustained usage discounts. As infrastructure becomes more efficient and costs go down, cost savings are passed on as well.

The downside of that strategy is you give up quite a bit of margin you may have been able to extract here and there. Which gets me to the point I wanted to make: The cloud business is highly likely to become an oligopoly with a limited number of providers competing with each other at a grand scale. Pricing in an oligopoly is more favorable to the firm than if it were a true free for all but the cost + model and the competitive environment will ultimately result in thin margins. Much, much thinner than the margins Alphabet can extract through its advertising business. That means even if the cloud business explodes and dwarfs advertising it doesn't have the same effect on the bottom line.

With that introduction let's look at some comments by CEO Sundar Pichai on the earnings call:

Our data centers, infrastructure, machine learning, and premium data services are leaders in the Cloud space as is our price-to-performance ratio. And we are now able to bring this to bear just as the movement to Cloud has reached a tipping point.

Like any CEO Pichai is very bullish on his company's product but I tend to agree Alphabet isn't too late to this party at all. Others may have been early and built somewhat of a lead but there is a huge market that hasn't been served yet. Again, a Holzle estimate, but perhaps 99% (emphasis added):

Businesses now see that the easiest-to-use, most price-effective and secure infrastructure can best be obtained through the major public cloud providers. Alphabet cloud platform is already used by more than four million applications. And we recently introduced a new way to purchase and use virtual machines, called Custom Machine Types, so that clients can tailor their purchases based on the memory they need to get the best possible cost and performance.

Its for these reasons I expect the market will turn into an oligopoly. The public cloud needs to be ultra secure, which means huge departments of expensive cyber security specialists. The best and most efficient data centers. Cloud providers that have the scale to migrate cloud needs across the globe and can attain high utilization rates of the servers. Alphabet's current infrastructure is a natural match and positions them well, just like it does Amazon. It does not surprise me Alphabet continues to heavily invest here and this may show up in CapEx in the short- and medium-term without an corresponding increase in EPS, which will lag this spending.

And I think we are at a point now where the product is ready to be used at scale. And so I expect to get significant traction in 2016.

Holzle said only a few months ago, Google had difficulty keeping up with demand. Citing it as one of the reasons Alphabet didn't step up its advertising. I suspect cloud is really going to be the Alphabet story through 2016 and as analysts start taking the future cash flows from the segment more seriously, price targets can be raised. Given its near monopoly in search, high growth rate, terrific operating margins, high cash balance, low debt and its cloud business getting very little credit I'm comfortable with Alphabet remaining solidly within my top five positions.

Disclosure: I am/we are long GOOG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.