It's not like me to talk consumer technology. As I've articulated numerous times in my posts and investment theses, I am generally not interested in investing in companies that are on the cutting edge of new technology. With consumer technology, the pace of industry change is too fast and product life cycles are too short, both of which contribute to higher risk. While not likely in my investment future, I do enjoy contemplating consumer technology strategy so what better than this forum to think out loud. Google (GOOG) released earnings yesterday so it felt like an opportune time to do some contemplating. I should put out a note of caution that I am by no means an expert on this topic. I just enjoy thinking through some of the various questions.
What's going on with CPC?
Google reported total revenue growth of 12% (or 17% ex impact of foreign currency) for Q1 2015. Double digit revenue growth ain't too shabby, but the devil is in the details and it may be worth better understanding some of the trends underlying that growth. The growth was driven by the continued trend of a decline in Cost Per Click (CPC) offset by an increase in the number of Paid Clicks. CPC was down -7% yoy while paid clicks were up +13% yoy in Q1. In fact, the last time that Google actually grew CPC was Q3 2011- about four and a half years ago. For the last several years, this has been driven by a few different mix shifts including platform mix (mobile versus desktop), product mix (Google.com versus Maps versus YouTube, etc.) and geographic mix (intl. versus domestic and currency impacts), among others. In the last two quarters, however, Google contends that the CPC decline was driven primarily by YouTube ads. YouTube ads currently monetize at lower rates than ad clicks on Google.com because video ads reach people earlier in the purchase funnel and thus they tend to have a very different pricing profile than a typical performance search ad. Excluding the impact of YouTube ads, CPC would have grew in the quarter. I don’t know if I completely buy into the provided rationale – YouTube is higher in the purchase funnel than search and thus commands lower CPCs. If this were the case generally, broadcast TV should have a lower CPM (Cost per thousand) than other channels that are lower in the purchase funnel, but this is generally not the case. I am more inclined to believe that YouTube is still proving out its value and there is less demand for ad inventory versus search given that it is a more emerging platform relative to search. However, I could see this change as YouTube further establishes itself and improves its effectiveness through basic learning over the coming years.
Putting the YouTube impact and platform/geographic mix impacts aside, I think that there may also be another factor at play here -one that Google doesn't discuss as much or at least not publicly. Google's ad system is based on an auction model and CPC is therefore partly driven by the level of competition for keywords. Thus Google has a fair bit of control over CPC. As with any supply and demand model, Google could drive price (or CPC) up by limiting the supply of ad inventory, yet they intentionally choose to increase ad inventory at the expense of CPC. Google is very data driven when it comes to this stuff so I am convinced that a higher number of paid clicks even though it is offset by a lower CPC is better for overall revenue.
Is Google lucky or skilled?
This brings me to my next question. Is Google growing revenue by executing well or is it just lucky? I am convinced it might be a lot of the latter (LUCK) with just a bit of the former (SKILL). There continues to be a secular shift from traditional advertising channels (TV, Print, Radio, etc.) to digital advertising (search, social media). Talk to anyone in the marketing world (brand managers and marketing managers at the largest companies) and they will tell you that they are dedicating more money to digital. Why you ask- #1) Senior management is telling them to; #2) digital is where the lucrative young millennials are- supposedly millennials aren't doing things like watching tv or reading print magazines anymore; #3) digital can provide higher ROI, better targeting and is more trackable than other channels. The thing is that these marketers aren't necessarily getting more money to spend, but they are merely shifting dollars from other channels. So the overall digital advertising pie is growing even though the overall advertising pie may not be. Even though the digital advertising pie is growing, I think that Google's share of that pie is decreasing. At one point Google represented the lion share of digital advertising. However, Facebook has emerged to become a force to be reckoned with in recent years. Not to mention other companies like Twitter and Pinterest that are vying for a piece of this growing digital pie. These companies are rife with ex-Google talent that can provide the know-how to build their own advertising engines. All of this isn't necessarily a bad thing. Companies can do really well and experience strong growth for a really long time while losing share of a pie that is growing very fast. I think Google is in this boat. Google should continue to benefit from this secular shift to digital in at least the near term (1-2 years). Eventually however, the music will stop and this shift will slow or stop and the advertising market will reach some type of equilibrium. I repeat that it may be a long time before this happens though and thus Google has the ability to be very successful in the near term by reaping the benefits of a smaller slice of a fast growing pie.
Where is Facebook winning versus Google?
Most marketers will tell you that there are really two types of marketing or advertising. Advertising that drives immediate sales (called Direct Response) and advertising that drives sales later (called Equity Driving). Google has always excelled in the former type of advertising. Generally, users of Google are going to the site with a very specific search or topic in mind. When users find what they are looking for, they click through to view content or sometimes make a purchase. In this way, Google is just a technologically advanced version of the Yellow Pages. People open it up to search for organic listings (which are free) and often come across larger ads (payed for by service providers) called Sponsored Listings. Imagine if the yellow pages guys had figured out how to transition their models to the online world. They would be the billion dollar companies of today instead of being bankrupt.
Facebook, on the other hand, excels in the latter type of advertising called equity driving. Users visit Facebook for discovery - they want to be engaged and entertained by pictures of their friends and videos of their family. And they may see an ad or two along the way. However, these ads would be very intrusive if they were text based ads trying to sell something. Thus advertisers go to great lengths to create ads that blend seamlessly (not always that seamless) into the organic content that users are looking at. These ads are typically trying to drive measures like greater brand awareness, consideration or perception by consumers through nice pictures and/or video. Facebook provides a nice platform to deliver this type of content versus Google which is largely text based. Thus more and more, advertisers are dedicating more dollars to Facebook to drive this type of brand equity messaging. I should note that Google's YouTube is a decent platform for this type of equity driving messaging but it is a relatively smaller portion of the revenue stream as compared to search ads. Google also tried to build out an equity driving platform with Google+, but when was the last time you used Google+?
What should Google do next?
Heck if I know, but I do know that the stock has been stalled for some time. Google has put tremendous effort, resources ad money into its many other projects and "moonshots" as they call it. But after all is said and done, the non-search revenue in the latest quarter is still only about ~10% of total revenue and it is likely that this other revenue stream is very low margin or more likely, loss generating. Now this doesn't mean that these "moonshots" couldn't one day grow to comprise a much larger portion of revenue and fuel future earnings. They definitely could but I haven't thus far been impressed with Google's ability to monetize its non-search innovations. Android is by far, the most ubiquitous mobile operating system from a share of install base perspective and yet, it seems like Google derives very little direct revenue or profit from it. Google Glass was supposed to change the future of communication (the Segway suddenly popped into my head) and yet I don't see anyone walking around with it. It seems like the strategy behind all of these innovations is to protect the search revenue stream which could be misguided. Maybe these innovations have the ability to live on their own and consumers are willing to pay for them. Google, however, is accustomed to giving things to users for free.
Google has continued to spend generously on R&D - 16% of revenue in the latest quarter versus 14% a year ago. There is a decent likelihood that some of these R&D investments will deliver high returns in the future. Phil Fisher (see my Reading List) might tell you that sustained R&D investment is a good thing, although he might harp on the effectiveness of R&D in the case of Google.
I'm going to go out on a limb here and make a somewhat bold call (maybe not that bold!) and say that Google's best near term investment may be one that further extends its strong advertising business model into a territory where it is weaker than its nearest competitor - equity driving advertising. Google should acquire Pinterest. Pinterest is only at the early stages of monetizing its content by incorporating advertising (they call it Promoted Pins) into its business model. The Pinterest platform provides a visually rich content experience that is particularly well suited to both equity driving advertising and direct response advertising via a commerce platform. Google's ad engine on top of this powerful platform could provide for a tremendous revenue opportunity. Users are already posting ad content on Pinterest. It's just a matter of monetizing it.
Anyway, that is all I will riff on for now. Inevitably some might agree with me and many will disagree with me, but that is what makes this fun. Speculation about the future when no money is on the line is the type of speculation I like and the only type of speculation I will engage in.