Many of the things that Bell Laboratories are proudest of now were done in spite of management.
--Walter Brattain, co-inventor of the transistor at Bell Labs
Google/Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) is a modern-day Bell Telephone that is wasting billions of dollars on fruitless research projects that will never significantly contribute to the company's bottom line.
Developing commercially successful innovations is extremely difficult and fraught with unanticipated failures, no matter how much engineering or business acumen is brought to bear on the task. To reduce such risk, many companies believe they can develop in-house ideas, buy early-stage research and partially developed products, or some combination of both. But there is no guarantee that such "advantages" will eventually lead to success.
Both Alphabet (as well as Bell Telephone in the past) has taken this route on sometimes too far afield products and technical advances. There are other similarities between Alphabet and Bell Telephone, too, I'll get into shortly.
The key here, though, is that Alphabet, and some other major modern tech companies seem to have not learned the lessons of the last generation of engineers and business leaders regarding R&D's role in commercial innovation and its management. Especially as it pertains to coming up with high-value commercial successes in relatively short time periods in order to meet shareholder and board of director demands. Major new innovations are rarely managed into existence.
Alphabet makes billions of dollars from Google's internet search service paid for by nearly everyone (corporate advertising, a cost eventually borne by consumers) and uses a portion of its earnings for far-flung R&D projects. That work is done in part at X Lab with other Other Bets segment businesses including Access/Google Fiber, Calico, Nest and Verily.
Bell Telephone was a company that made a correspondingly large amount of money for the time from phone service revenue paid for by nearly everyone with a telephone, and used a portion of its earnings on far-flung research and development projects. That work was done at Bell Labs.
In both cases, huge earnings came to the respective companies during their heyday. So much so that corporate leadership believed they could use a small percentage of these earnings to take truly exploratory chances in research and development with the plan (in the hope) of coming up with their next blockbuster innovation as well as to protect the technological competitive advantages in their industry.
In both cases, that small percentage of earnings turned into very large absolute dollar amounts and significant R&D efforts.
Bell Labs was one of the world's premier research and development centers of the last century. Their research led to 11 Nobel prizes. But by the mid-1990s, the decline in funding as a consequence of low cost effectiveness was already underway. This was understood by Bell Labs staff as the result of several factors:
- There are simply few big technical successes in industry.
- Better technology doesn't always prevail, other factors often drive success.
- In most cases, there are many competing technologies possible for solving the same problem.
- New technologies need to be made to fit into an ever more complex world, which constrains novel solutions.
- Incremental improvements tend to be more commercially viable than revolutionary ones.
- Commercial innovation is not assured by the combination of money plus talent, as management often assumes.
Corporate America, such as General Motors (NYSE:GM) and their research lab, began dumping "moonshot" R&D more than a decade ago. In spite of many successes, the cost of doing exploratory R&D came at a high cost relative to the short-term growth expectations of corporate boards.
By the mid-2000s, the balance-sheet-induced pressure was clear. In 2008, Bell Labs made the decision to move out of exploratory research and concentrate on immediately marketable ideas.
Alphabet's R&D branch is intended to allow for high-risk, high-reward efforts that could produce commercial products and services of such magnitude that they can contribute to Alphabet's very large bottom line (hence, a moonshoot). They bookkeep these efforts under their Other Bets segment. While this name is a play on Alpha-"bet," it also highlights the very real gambles, or bets, that they include.
Alphabet spent 15% of their $23.4B earnings, or $3.6B, on moonshots in 2015. That was 83% more than 2014. They are on track to spend billions more in 2016 with an $802M first quarter "Other Bets" operating loss.
Here is the crux of my argument. Alphabet revenue will be around $80B in 2016. To make a 10% positive impact on that, you'd need to come up with a new business that adds $8B/year in revenue today. That number will presumably keep growing every year.
Do you really think such a business, or combination of multiple smaller businesses, will pop out of the "Other Bets?" I believe that to be very unlikely. Nearly $10B/year is a very large revenue stream, on the order of creating a new eBay (NASDAQ:EBAY) or Priceline (NASDAQ:PCLN). In the meantime, Alphabet is spending on the order of $3B/year of earnings to create such a new business, or one they hope will be much greater.
So why did Alphabet go off on this tangent, and why is it still on it?
My take is that successful founder hubris biases companies into thinking they will be able to succeed in any new high-risk endeavors. Executives with a start-up mentality, especially those who founded super-successful high-tech companies, often believe that what they did to achieve their success had little dependence on external factors and can be repeated if they just try. They think they are savvy enough to buy their way into successful new ventures with the right R&D-stage company buyouts and the hiring of top talent. But this is very rarely the case. They fall into the trap of the last Bell Labs' lesson learned bullet above.
But neither innovation likelihood nor time are on the side of today's major high-tech businesses. Corporations generally lose risk tolerance as they mature and their boards of directors push for a stronger bottom line, cutting timelines short.
So, like the high cost of occasionally successful Bell Labs' innovations, Alphabet is repeating corporate mistakes of the past, trying to intentionally capture lightning in a bottle for a second and third time. Google was a one-time moonshot after all.
The realization of this unlikelihood is starting to set in. Alphabet is finding out they can't easily innovate big successes just by managing acquisitions in the style of their corporate pubescence. They are implementing R&D business targets. Boston Dynamics is being sold (the acquisition price was not disclosed). Nest Labs, a $3.2B acquisition, is seeing brain drain, leadership resignations and general staffing unease along with weak commercial sales growth. Virtual reality projects are being scrapped.
I wonder who will buy Alphabet's rejects? With all the resources in the world including some of the best technical minds in the industry, if Alphabet can't get these innovations to work or be profitable, who will? Expect big dollar losses on the sales or write-offs of Alphabet's failed purchases.
There also are losses of opportunity arising around these failed or failing projects and acquisitions, and these are leading to an inexorable reduction of expectations. Don't count on moonshot R&D to lead Alphabet's future growth.
Alphabet is wasting too much money on high-risk, failing ventures with very low chances of reaping sufficient reward. They should be concentrating more on protecting and growing their core company, Google. They don't need to take on the risk and waste of moonshots.
But don't get me wrong, Alphabet should continue investing heavily in technical innovation closely related to the Google empire, including artificial intelligence and machine learning, among other things. That is where the risk-taking should occur. And if they continue to generate excess funds beyond that need, I'm more agreeable to a strategy like Apple's (NASDAQ:AAPL) low R&D relative to earnings, cash stockpiling and dividend payout.
Alphabet, and other similar financially well-positioned tech companies, need to learn from the past to optimize their future. Losing money to relearn old mistakes is just bad leadership. Bell Labs' lessons learned were not that long ago and are still applicable.
Interestingly, Alphabet seems to be "stepping back" now instead of forward. Especially with Alphabet's Google Fiber reaching low with a high-tech solution, offering inexpensive telephone landline service. And Google is now coming up with its own phone. It's almost a purposeful transformation back toward the modern equivalent of Bell Telephone's heyday.
That path may be a good move in the long run. Alphabet should keep cutting their high-tech moonshots and supporting lower-reach core technologies. There are better ways to serve your shareholders than wasting billions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.