Does Google have any growth left? – Alphabet | Summer Series

Bryce: [00:00:16] Welcome to the Equity Mates Summer Series, proudly brought to you by CommSec, the home of investing over 12 episodes where deep diving into some of the most exciting, interesting and well known companies from around the world. Each episode will be unpacking one company with one expert. Will learn from their process and hear why they like the company. My name is Bryce and as always, I'm joined by my equity buddy, Ren. How are you? 

Alec: [00:00:38] Bryce, I'm very good. I'm very excited for this episode. We are talking about a well known company. A big company. But a company that is on the cutting edge of the next wave of technology. I mean, it could be any of the big tech companies.

Bryce: [00:00:56] The Magnificent Seven. 

Alec: [00:00:57] But the company we're talking about today is Alphabet. And the expert that's joining us to unpack it is Mary Manning, a portfolio manager at Alphinity Investment Management.

Bryce: [00:01:07] How big can Alphabet get? That's what I'm excited to unpack today. 

Alec: [00:01:11] Well, you can ask that. You can ask that to Mary. Before we speak about Alphabet or put any questions to Mary, we've got to say a big thank you to CommSec who are proudly supporting the Equity Mates Summer Series. If the Equity Mates content isn't enough for you, CommSec has a content hub stocked with all the support, information and resources you need to build confidence and make the right money moves. Get $0 brokerage on your first ten trades for Australian markets when you join. Download the CommSec app today or visit CommSec.com.au, CommSec T&Cs and other fees and charges apply. 

Bryce: [00:01:47] And just a reminder that while we are licensed, we're not aware of your personal circumstances. Any information on this show is for entertainment and education purposes. Any advice is general?

Alec: [00:01:56] Now, Bryce, before we speak to Mary, let's unpack the company it ourself. It's a company that doesn't need a lot of introduction. Alphabet the parent company of Google. I guess that is the introduction it needs. And it's a company that, like will get into the business. But I think where we need to start is just what has happened, even just over this summer, because the arms race is on. And it was pretty clear that 2023, Microsoft and Openai were out ahead. But in December, like right before Christmas, when everyone was switching off and getting ready for for summer, Google released their Gemini paper. 700 co-authors, including Sergei Brin, the Google co-founder. You kind of love to say that apparently he was involved on the tools involved. Wow. Like that's a technical co-founder. Yeah, but apparently, obviously, we're not experts. But from all the reporting, what they have built is just next level. 

Bryce: [00:02:57] Yes. So just to put some colour to what Gemini is, it's the GPT four equivalent. I guess, large learning. What is it called, like a large language model like back end to support. Yeah. Whatever it is, what wants to be built on top of it. And the market loved it. At the time that they announced it, the stock jumped.

Alec: [00:03:17] It was. 

Bryce: [00:03:17] About 7%.

Alec: [00:03:19] I was I thought it was up five and a half percent the day after it was announced. And five or 7%, if it is like that, almost $2,000,000,000,000 trillion company, that's billions of dollars of value added. So it's it's probably too early for us to really have a good gauge on what it's going to mean. But this Gemini AI is going to now power the Google powered chat bot and I'm sure a number of other initiatives that we'll see rolled out in 2024. But I think that context is is relevant as we start to talk about, you know, its operating segments and Alphabet as a business today. It's that it's underpinned by some you know, you probably don't think about it as cutting edge as maybe some other tech companies but like it's it's number of AI researchers and PhDs per square foot is higher than any other company in existence, and it's starting to flex that muscle. 

Bryce: [00:04:15] Well, let's get to Alphabet, the business, Ren. It's a company that doesn't need a lot of introduction, to be honest. But I'm glad Mary has brought this to the table, because often when you see huge companies like this, you kind of think, what is the investment thesis here? We know what it is, how much bigger can it get? So I'm really interested to hear Mary's view on this. But if you are unaware of what Alphabet does outside of just its search, it is obviously a large conglomerate that offers multiple products. It has three reportable segments Google Services, Google Cloud and what they call other bets.

Alec: [00:04:54] Okay, that's really not the most descriptive way to break up the company, but let's talk about that and then maybe we'll talk about how we would break it up. 

Bryce: [00:05:02] Sure. So how they break it up, Google Services encompasses obviously search, it encompasses YouTube, it encompasses their ads program primarily that's it. Google search is enormous. It's I think, has over 90% market share like it is Google. And that Google services. The second component is cloud competing with the likes of Azure from Microsoft and AWS, I think it's the third largest player though, in the cloud space. And then finally, is there other bets? That's where they take a lot of their free cash flow and invest in things like Waymo. What other artificial intelligence? 

Alec: [00:05:43] So, I mean, artificial intelligence is throw out, but Waymo, which is autonomous driving, wing which is drone based delivery. They've got Calico, which is their anti-aging business. They've got Isomorphic Labs, which is using A.I. for drug discovery. They've got intrinsic, which is robotics, a lot of very sexy industries to play in. Not a lot of money being made. 

Bryce: [00:06:13] Not a lot of money being made at all. And in fact, quite a lot of money being lost in the other bets component. 

Alec: [00:06:19] So Waymo for me is an interesting one. And we can we can go back and talk about Google's business more generally. But just on Waymo, for about the last five or six years, if you've been in Phoenix, Arizona, you've been able to pull out your phone, open an Uber like app and order a Waymo self-driving taxi to drive it somewhere, which is amazing. Like a driverless car has been taxiing people around Phoenix, Arizona, for like the last five or six years. The problem is the technology that they've built is incredibly non scalable. It's incredibly bespoke to each city. And so for five or six years they've been in Phoenix, Arizona. They've just got to their second city, San Francisco. So this right, we might get it in Sydney but for 2060 still pretty cool. 

Bryce: [00:07:10] Yeah well yeah I mean cool. Yeah it is. That is, that is cool. I'd love to experience that. 

Alec: [00:07:16] But we just going to go to Phoenix, Arizona. 

Bryce: [00:07:17] No. Maybe business trip next year, we'll see. Anyway, back to the business, Ren. So let's break down Google Services a bit more because this is where the majority of the revenue comes from, and that is things like the Android, Chrome, Google Maps, Google Play, YouTube, search. They use all of that to essentially generate advertising revenue. Yeah, And that is the bulk of the business. I think something like $280 billion in revenue comes from that part of the business from a total of almost 300 billion. So. 

Alec: [00:07:49] Which is why we said it's probably not the best way to break up the business into those three categories.

Bryce: [00:07:54] No, but that's just how they report it. 

Alec: [00:07:56] I know. I'm saying I understand what you're saying. Yeah, but I'm saying. 

Bryce: [00:07:59] I'm surprised that YouTube falls under that. I think I have in my mind that YouTube is way bigger than it is to Google, if that makes sense. 

Alec: [00:08:07] Yeah, well, like they would say, the reason that it makes sense to break it up that way is all of those different constituent business parts do different things but make money the same way advertising turning our data into advertising. So like YouTube, Search, Android, all of it is just a function of telling us what to buy. And God, they do a good job. 

Bryce: [00:08:29] They do. They do. I think YouTube roughly makes 11% of Google of that chunk of revenue.

Alec: [00:08:35] So it's not small. 

Bryce: [00:08:36] Not small, no. The second part, as I said at the top, is Google Cloud. Now, this is one of the faster growing parts of the business made revenue of sharp of $27 billion. So still, in the grand scheme of things, what about 10% of total group revenue? 

Alec: [00:08:51] And most people wouldn't think that they're customers of Google Cloud, but in the sense if they used jiggle drive and gmail. 

Bryce: [00:09:01] Gmail. Yeah. 

Alec: [00:09:01] Does that fit into that? 

Bryce: [00:09:03] I don't know. I think cloud, the way that I understand it, is that they are what. 

Alec: [00:09:08] Is it more like AWS style? 

Bryce: [00:09:10] Networking is how I would, how I think of it like their enterprise level Google workspace stuff. 

Alec: [00:09:18] But that's like we use enterprise. 

Bryce: [00:09:21] Yeah, we use the cloud. Google Cloud. Yeah. 

Alec: [00:09:23] Yeah. But it's just Google Drive. But they'll be pay for. 

Bryce: [00:09:26] I guess so. Sure. That's not how they would put it but. 

Alec: [00:09:30] It's the same shit. Technical term. 

Bryce: [00:09:34] Technical term. Yeah. But I think the cloud business is the part that excites or that is growing the fastest or not growing the fastest but is growing faster than other parts of the business. And we've spoken about other bets. Just to close out the numbers on that, the other bets part of the business, I think they generated just over a billion in revenue, but over $6 billion in operating loss in 2022. So the other business. Yeah, Yeah. So losing a lot of money there. 

Alec: [00:10:02] Yeah. But imagine if they nailed just one of them. 

Bryce: [00:10:05] True. Yeah. Waymo.

Alec: [00:10:06] And that's that would be the internal pitch every year for funding. Imagine. So I think when we're thinking about. I'm interested to see where Mary's thesis lies is that it's kind of, it's kind of done, it's Dash is. And, you know, full disclosure, it's one of my biggest single stock positions. I'm not arguing this, but I think the consensus view of a lot of people is that Google search is as dominant as it will ever be and it will just grow in line with population growth and GDP. But there's not a massive untapped growth opportunity there. Cloud It's the third player in a growing space, but it's the third player. Like if you're interested in cloud. Go to Microsoft or Amazon and then YouTube's good, Android's good. The ad serving marketplaces is good, but they're all pretty saturated. Like, you know, you don't see a path to doubling any of that. And other bets, other bets like they're moonshots there. So that's kind of the consensus around Google, I feel. And that was definitely why the share price fell so much in 2022, that people saw it as like a bloated behemoth that would not go anywhere but wouldn't run anywhere quickly. And then obviously ChatGPT comes along and everyone's like, Oh, is this going to be the first real threat to Google search? That probably hasn't eventuated yet. But I think that story, that picture that I'm painting is kind of the consensus view of Google. Do you think that's fair? 

Bryce: [00:11:53] Just like how much bigger can this thing get? 

Alec: [00:11:54] Yeah. Yes. Now, what we saw in the most recent set of numbers is that that bloated behemoth Bama bloated behemoth trimmed down a little bit, just like everyone else in America, having trimmed some fat and. 

Bryce: [00:12:11] Cuts in costs. 

Alec: [00:12:12] Its revenue grew, its revenue grew. What, like 20% or something? Oh, these are the numbers I'm pulling. But from memory it's revenue grew about 20%, but its profit doubled. And that was a story of managing their costs and that got everyone pretty excited about it again. But I still think the long term question about where does the next leg of growth for Google come from is the question on a lot of investors minds. 

Bryce: [00:12:38] Yeah, well, we can put it to Mary. They're so big, all these large tech companies that they continue to surprise us year on year. 

Alec: [00:12:46] Well, they get broken up, that is you know.

Bryce: [00:12:48] Yes.

Alec: [00:12:49] They're in court. 

Bryce: [00:12:50] They've been in court for decades trying to be broken up. 

Alec: [00:12:52] That's true. That's true. 

Bryce: [00:12:54] Now, I just want to say the YouTube story fascinates me. They acquired YouTube in 2006 for 1.6 billion. 

Alec: [00:13:03] Okay. It was a straight billion. No, I think you're right. 

Bryce: [00:13:05] Yeah, 1.6 billion. Now, YouTube made revenue of 30 billion in 2022, so they're making about one and a half billion dollars every three weeks. 

Alec: [00:13:16] Yeah, yeah, yeah. Pretty good.

Bryce: [00:13:19] Absolute. 

Alec: [00:13:20] It's just it's such a dominant platform. And like we the industry that we're in way say it and if you're watching this on YouTube, make sure you give us a like and subscribe. And if you're not watching this on YouTube, you can be. But it's so dominant and so dominant with younger users as well. Like everyone's raving about TikTok, YouTube is bigger. 

Bryce: [00:13:44] It is right up there.

Alec: [00:13:45] I think the stats are in the US, 64% of teens use Instagram regularly, 67% use Tik Tok regularly. 95% use YouTube regularly. 

Bryce: [00:13:55] Yeah, yeah. It's fast becoming the TV replacement for a lot of them. 

Alec: [00:14:01] Already is. Yeah. Like we saw our mate Elton in the States and YouTube TV is like live TV.

Bryce: [00:14:09] It's still such a small part of Google Now that I'm thinking about it though. 

Alec: [00:14:12] That's just Google is massive. Google is 1.7 trillion company. 

Bryce: [00:14:18] That is crazy. 

Alec: [00:14:18] Yeah, I guess don't lose sight of that though, because you can get so excited about so many different constituent parts of Google, but your investment thesis has to correlate with their relative positions in the company. And that's a convoluted way of me saying YouTube could double its revenue, go from 30 bil to 60 Bil. Yeah, be an incredible growth story. Yeah. And if Google's search falls off a little bit. Yeah, all of that value is eroded. 

Bryce: [00:14:47] Yes. Well, that's a great segway. Let's bring in Mary, because I am very interested to hear what forms her thesis for a company of this size. And yeah, is that that search doubles from here or is it that YouTube doubles. 

Alec: [00:15:03] I'm going to love it if it's the drone delivery stuff. 

Bryce: [00:15:06] Now before we bring in Mary, CommSec is the home of investing and if you want to start small you can through the CommBank app, you can invest with as little as $50. Consistent small amounts can add up to meaningful returns. Visit CommBank.com.au For more CommSec tenancies and other fees and charges apply. 

Alec: [00:15:24] We'll be right back with Mary after this short break. 

Bryce: [00:15:37] We're here with Mary Manning. Mary, welcome back to Equity Mates. 

Mary: [00:15:40] Thank you so much for having me. 

Bryce: [00:15:41] So to kick things off, we all know Alphabet. We've all used many of the products, Searchm YouTube, you name it. So the question that we want to start with is how do you actually think about Alphabet as an investment and going beyond what we just know it as today? 

Mary: [00:15:59] Great question. To start out, at Alphinity, we look for earnings leadership. So those are stocks that are in a beaten cycle and where there's lots of momentum in the earnings. So for any stock we look at, including Alphabet or I'll call it Google, you know, as we as we go through, because that's how most people refer to it. We are looking at what's happening to the earnings. So if you back up a little bit and look at what drives the earnings, there's obviously four different parts primarily that drive revenues. So that Search, which everybody is very familiar with, YouTube Cloud and then other bets. So we look at those four businesses separately and see where the momentum is going. And then one aspect of Google, which has become much more important in the last 12 months is the cost of the mega-cap tech companies. After years of just spending and hiring sort of with no brakes on, they have started to focus more on cost. And that is a big part of the Google earnings turnaround story. And then lastly, we do look at CapEx and with the whole push towards AI, there is a lot of expenditure both in OpEx and in CapEx for Google. So those are the sort of components that we look at and then we look at together taking those together. How is there momentum in earnings and are those earnings going to beat what is expected by the consensus on the street? 

Alec: [00:17:08] So I think, we'll drill down into some of those constituent parts throughout this conversation. But let's start with how you're analysing it. And you mentioned a few really key metrics there around the financials, earnings and then also they're beating their estimates that they're putting out or that Wall Street are making. When you're looking at the business metrics as well, what are the things that you want to see as investors across those different constituent parts? 

Mary: [00:17:35] So let's start and go through by each business unit in search. Search is primarily digital ads. So what we're looking for there is revenue growth and potentially or preferably accelerating revenue growth. So that's the part of the business model in Google, which is actually tied to the economy. A lot of statistical analysis shows that digital ad spend has to do with where general GDP growth is going and particularly where personal consumption expenditure is going. So we look at those digital ads and see whether there's momentum in digital ads. The second part is looking at YouTube. That's also an advertising business. So we look at YouTube, just overall revenue growth and the acceleration or deceleration of revenue growth, but also subscribers. That's a part of the YouTube business, which is slightly different than Search. And then on Cloud, you know, there's three main hyperscalers, Azure, which is owned by Microsoft, which is Amazon, and then GCP, which is Google Cloud Platforms, which is Google. The other two are sort of big behemoths. And Google Cloud is quite small. So for that, we look at actually three different metrics. One is, is cloud growing. The second is cloud growth accelerating. This has been a very big thing for all of the hyperscalers. They're still growing, but it's been at a slower rate. And then the third thing is looking at profitability of cloud, because for many years cloud was growing on the top line, but it was sort of a land grab. And so that business was actually loss making at an operating profit level very recently and for reasons which we can get into later. That business has become profitable. And then other bets, we're not really looking at revenue growth. We're actually just looking at whether those are profitable and whether there are any. Maybe I should back up a second. Other bets is sort of like an internal R&D, private equity VC, part of Google. To be frank, it's been quite disappointing, given all of the technology expertise and the AI expertise and the firepower and brainpower at Google. The fact that they haven't come up with any unicorns since other bets started, or certainly any unicorns that have been listed separately and that have provided value to the Google shareholders is a concern. So basically, I just look at other bets, see if there's anything in there that can become a success later on. But for in the more immediate term, I'm looking at whether that, you know, how loss making that business is. Because if you're looking at EPS and you have a big loss, come through with other bets on a quarterly basis, it can create a miss. 

Bryce: [00:19:55] Of all the business units, which one excites you the most? 

Mary: [00:19:58] I would say Cloud, probably because, you know, search. Everybody knows it. Everybody uses it. It has a massive moat around the business. They have 90% market share globally. And in most, you know, some countries it's even higher than that. So it's hard to see a scenario where Search gets better. Search is just the sort of cash cow that continues to move along. The thing about cloud, though, is it is very nascent. It's a fraction of the size of of Azure and AWS, and they have quite a different client base. So Azure and AWS, they deal with sort of top 100 companies. They have very big enterprise businesses. But Google is dealing more with sort of SMEs or they call it small and medium business, SMB and AI Start-ups. And so if you look forward, you know, ten, 15 years. Things that are AI start-ups today might be mega caps ten, 15 years from now. And I think that's really exciting. And the second thing from a profitability perspective is Google Cloud. As I mentioned before, it used to be loss making. And then the last quarter, the op margin was only 3%, whereas AWS, for example, is somewhere between 26 and 30%, depending on what quarter it is. So you can see a scenario for Google Cloud where it gets much, much, much bigger and the operating profit margin is like triple or quadruple what it is now. And I think that's pretty exciting. 

Alec: [00:21:09] Yeah, that is exciting. And I imagine that's a key part of the bull case. When you're thinking about Alphabet, is it really just tied to that business unit or is there a broader investment thesis that you have at the moment? 

Mary: [00:21:20] There is a much broader investment thesis. So Cloud, you know, I did this analysis even though cloud has probably a really exciting longer term outlook. If you take out the cloud. Operating profit on a quarterly basis, it makes like low single digit impact on EPS. So it has the best long term story. But on a quarterly basis, it's not swinging the dial between beat and raise or a miss, but at a more high level investment thesis. I think Google is an AI winner is the number one exciting story because if you cast your mind back to maybe a year ago now when ChatGPT first launched and there was this whole thesis out there that Google wasn't going to be a major loser and that Bing was going to take over. And you know, really who uses big? You could do a straw poll.

Alec: [00:22:05] I remember a few podcast episodes. Bryce was saying that. 

Bryce: [00:22:10] I don't think I was backing Bing, but I was backing 

Alec: [00:22:13] You were saying this is the first I think your quote is this is the first time I say a real threat to Google. 

Bryce: [00:22:17] Oh, yeah. True disruption. 

Mary: [00:22:20] So I think, you know, my, my it was quite interesting because at the time, if you looked at some of these AI winners in AI losers like ETFs, Google was in both of them. So it was a very bifurcated view of Google's going to be a loser or Google's going to be a winner. I have always been in the winner camp because I feel that Google is like the original AI stock. And before anyone was talking about AI, before there was ChatGPT or Anthropic or opening AI or any of these things, Google's whole search business runs on like those are the algorithms that are that are matching the ad buyers and ad suppliers, and that is there's a whole AI focussed algorithm that is giving the results on search. So it was sort of like Google's the OG AI company, but people just forgot about that because there was a new exciting thing come on with ChatGPT you.

Alec: [00:23:07] Didn't they also buy the actual OG AI DeepMind or. 

Mary: [00:23:12] Yeah, yeah, yeah. Yes they did exactly. And from a pure research perspective like DeepMind, they've actually just changed the organisation of Google, so that will be easier to see what DeepMind is. It's not a profitable business but, but the like from a more academic perspective, the research that they do in DeepMind is very, very important and it's, as you rightly highlight, it's been going on for years and years. This isn't something that popped up last November when ChatGPT launched. So I think that aspect of Google, that it is an original AI stock, sort of got completely overlooked when all these other things took off. And I think that's one of the important drivers of Google long term. 

Bryce: [00:23:53] So no mention of YouTube here, which for us feels like we're both shareholders and I'm a massive YouTube user and when, you know, just in the business that we're in looking at how younger people are consuming media, YouTube is number one if not.

Alec: [00:24:09] Yeah. 

Bryce: [00:24:10] So close to from TikTok. 

Alec: [00:24:11] So the stats you know everyone talks about us teens on Tik Tok and the stats are about 64% of us teens are regular users of Instagram, 67% Tik Tok. And then it's like 95%. 

Bryce: [00:24:25] And watching hours a day.

Alec: [00:24:27] It's just wild. 

Bryce: [00:24:28] So where does YouTube play in your thesis? 

Mary: [00:24:31] So I like YouTube. I agree with you. You guys actually probably know the stats, so I will defer to you on this one. I definitely like YouTube, but it's just important to keep in mind how big it is. So YouTube revenues are about the same as Google Cloud, so YouTube can do very, very well and it's an ancillary driver. It gives a little bit more momentum. But if we ever gotten to a macro situation where digital ads was rolling over, YouTube wouldn't be enough to save it. And also the ad business of YouTube would probably roll over at the same time. So it is very exciting. One thing I think we should all watch going into the US presidential election next year is actually what happens to Tik Tok, because you remember last time during the election, people like to sort of, you know, gang up on Chinese companies and Trump wanted to ban it and etc.. And you know, the stats that you just said, they do have big market share. They're a big competitor to YouTube. And if that ever got banned in the US or it looks like it's going that way, that would definitely be a win for YouTube. So like the YouTube business, it's run very well but it is smaller in the context of. 

Bryce: [00:25:29] Which is just crazy to think about given how massive it is as a platform. 

Alec: [00:25:33] TikTok or YouTube? 

Bryce: [00:25:36] Youtube. It's just. Yeah, it's almost insignificant. 

Mary: [00:25:41] Like there, the revenues are roughly the same as Cloud, but obviously it's much more profitable. But yeah, you, you couldn't just buy it from Google because you like YouTube. Because it could get swamped by other parts of the business earnings level. 

Alec: [00:25:53] Yeah. Yeah. Yeah. Well that's why maybe it gets broken up one day and then Bryce can just buy YouTube. But it got to that. So we'll get to that when we talk about the Bear case because there's a few different, I guess, threats that we should talk about. But let's stay on the bull case for now. So, you know, there's the AI winner story, there's the earnings beat story. And the turnaround from a cost point of view has been pretty remarkable. Potential in Cloud potential in YouTube. So there's a lot of things to like. Is there anything else that we haven't spoken about? A note that we haven't spoken about other bets, Any flies you want to take there, or are those components the main parts of the thesis? 

Mary: [00:26:37] I would say two things. First of all, we should dig a little bit deeper on the cost side because, you know, big tech, they got quite lazy when interest rates were near zero and, you know, they could just spend, spend, spend, spend. It was kind of like throw spaghetti at the wall and see what sticks because there's enough cost to be able to support a whole bowl of spaghetti. And I think now it's a very different environment. There's been a lot of cost control, particularly in last year. In 2022, a lot of these stocks went into a deep earnings downgrade cycle. So we held Google sort of throughout COVID and the big boom afterwards. And then we sold it completely out of the portfolio because it was in a deep earnings downgrade cycle. And that's not when we hold stocks. And then we bought it again very early this year. So cost control is important. And one thing we joke about internally is there's this news release. It was maybe six or eight months ago now saying that Google was cracking down on costs and they were removing staples from the office and they were taking dried mango out of the kitchen and everybody was laughing like, come on, this is $1,000,000,000,000 plus market cap company that you have, you know, hundreds of billions of sales and costs. And you're going to generate cost cuts by removing staplers. Like when was the last time you guys use a stapler? You know, I mean, but I mean, you don't dried mangoes like really And so everyone was laughing there, all these means. But if you take a step back, that's actually a very positive thing in my view, that there's someone whose part is as she's moving on as the CFO, but she was the CFO at the time that someone in her office was going through Google's income statement and cost structure to the extent that they identified dried mangoes and staplers, that's showing a level of focus on cost cutting that we've never seen from companies like Google before. So I think that that's quite positive. Google is different than companies like, say, Meta. So Meta they really threw the spaghetti at the wall. They were just going all out on cost. Their cost structure doubled over a few years and now they're actually cost cutting. And that's been a strong story for metal. Also, Google isn't cost cutting in terms of the cost basis. It's actually going down. But the cost growth is definitely in control. And because revenues are growing so nicely, they have a very positive jobs story. So I like the cost cutting story. They do have a new CFO coming in. So Ruth Porat, not this most recent quarter, but in the August results they said that she's moving on from CFO. She is going to focus as CIO on other bets, which we can discuss whether that's going to be positive or negative to turn around. They have not announced who's going to be the new CFO. Now, they've said that Ruth is doing the planning for 2024, but we're not sure who's going to come in. And it's actually remarkably quiet. Don't know if it's an internal hire, an external hire, if it's a tech person. Remember, Ruth came from Wall Street. So there's really not very much information. But I'm watching that very closely because whoever comes in, it's important that they are also on the cost cutting. You know, they don't abandon that sort of focus on cost cutting. 

Alec: [00:29:23] So how do you balance that in like there's two conflicting stories, almost like on one hand, it's controlling costs and just saying, you know, revenue grows, but earnings grow a lot faster because you're controlling costs. And then on the other hand, there's this massive AI boom, which is incredibly capital intensive and there's a lot of spending going on and it probably will require a lot of investment to position themselves and win. So is it just you who wants to see the right type of spending and what is the right type of spending? How are you sort of holding those cut costs but also spend where you need to thoughts? 

Mary: [00:29:58] That's a great question. So two things. First of all, you're right. It's what kind of costs there are. So if Google says we're hiring more people, I want to know that they're hiring AI engineers. They're not just hiring random people who are not going to generate any profit. So like, that would be a specific example. Secondly, the difference between OpEx and CapEx. So there does need to be a lot of CapEx to generate the sort of AI revenues going forward. So that's important. And then on the OpEx front, looking at what's R&D and what's just other sort of OpEx. So that's sort of how I'm looking at it. You're right, now is the time when you want to be leaning forward in terms of AI. Want to get caught up in the sort of cost cutting narrative and sort of miss the boat on AI. I think thus far Google's done a pretty good job of making sure that they're moving forward on AI while continuing to control costs and on other things.

Bryce: [00:30:48] So, Mary, let's move to the bear case. And can you give us a sense, just a high level of what you're sort of looking for in terms of red flags or or metrics that you're tracking to see if this thesis might start unwinding? 

Mary: [00:31:02] The first thing I'll say is very high level. So obviously, Magnificent Seven has done amazingly well this year. And if you look back through history, mean reversion generally. So my biggest concern about Google is actually not about Google as a stock. And I'm not not answering your question, but the thing that keeps me up at night is that you would have some massive mean reversion so that all the megs sevens go down next year. And, you know, the Russell 2000 absolutely takes off. And if you look at valuation differentials, if you look at performance differentials, you can make a case that there should be some mean reversion out of the Meg seven. So that's an important concern. We have our two largest positions in our fund right now. Are Microsoft at around 7% or over. And then Google is next at between six and 7%, depending on the fund. So those are big you know, if Meg seven rolls over, that's that would be quite significant for us. One level down from that, it's macro, but it has very important implications for Google would be if you have a hard landing in the US and particularly a hard landing for U.S. consumers. Because as I mentioned previously, a lot of statistical analysis shows that digital ads is very highly correlated to personal consumption expenditure. And if you have, you know, Fed stays higher for longer and the US consumer rolls over and that digital ad cycle goes into a negative part of the cycle, it's very hard for Google to perform well in that sort of environment. 

Alec: [00:32:22] Let's hold on. I'm sure there's other elements that you're watching, but on that, looking at the consumer and thinking about where they're at and hard landing, soft landing US inflation came in at 3.2% for the 12 months to October, and it seemed like the market all breeds a sigh of relief. How you saying that? And like, I guess probabilistically, how are you thinking about the chances of hard landing, the soft landing?

Mary: [00:32:45] So as we discussed, when I arrived, I've just been in the U.S. for two weeks and met with a lot of consumer companies. Part of my goal in going was to get a view on where the US consumer is. And unfortunately I do not have a on the table. This is my view on U.S. consumers because across the board, almost every consumer company I met with and even companies like Amazon or e-commerce, they don't have very much visibility. So I said, you know, we're going into Black Friday and Cyber Monday. Can you give me an idea of how things are tracking? We don't have very much visibility. So I feel like companies, they either don't have visibility and they don't know or they're so nervous about it that they're not willing to tell investors. But both of those suggest that there's just not that much visibility. I personally don't think that there's going to be a hard, hard landing, mostly because of the very basic point that unemployment is still very low. And if you look back throughout history, you generally don't have a hard landing until you get a spike in unemployment. And we're not seeing that yet. So I don't think we're going to have a hard landing. But whether it's going to be super soft or, you know, medium hard, I don't have a strong view on that. I think we will get a lot more information at the January set of results. So that's a result that I'm looking at very closely for consumer related and digital ad related spending stocks. 

Alec: [00:33:57] So are there other things that you're watching out that could break your thesis or have you concerned? 

Mary: [00:34:02] So on cloud, we need to see cloud at least stabilising. So there's some very interesting words being tossed around by the major cloud companies. So at first things were optimising, which was sort of like a euphemism for they're getting worse. But we don't, we don't want to say that they're getting worse. So for almost last year they were saying that the large clients are optimising and then it was stabilising. So growth is, you know, that it was decelerating, but now it's stabilised. And then last quarter Amazon came out with this new world called Attenuating, and they kept saying cloud growth is attenuating and well, Google. I was like Googling, attenuating to make sure I knew exactly what it means. So one thing we need to see all these cloud companies inflect like I don't want to hear about optimising and stabilising and attenuating. I wanted them to say things have inflected, we are growing and we're growing and we're accelerating pace so that we need to see that sometime in 2024, if for whatever reason the cloud continues to decelerate or if those growth rates are dropping off, I think that would be quite negative for cloud. 

Alec: [00:34:58] Attenuating reduces the force effect or value on a just thought you might want to know because I want to Google it as well. 

Mary: [00:35:07] So that's what we were saying. Is attenuating better or worse than stabilising because stabilise you're going like this in attenuating suggests you're still going down. 

Bryce: [00:35:16] Yeah. Well it's not as intense.

Alec: [00:35:18] I would suggest that the fact they needed to change their word to something else means that it's getting worse. Yeah, yeah. 

Bryce: [00:35:23] Yeah. I was just going to say just on that Mary, so obviously you're watching the quarterly earnings pretty closely and making decisions based on that. But for the retail investor sitting at home who, you know, it's hard to sort of get out of the cycle of every three months. Google is throwing earnings results at you. How do you treat the earnings cycle and how many do you give before you make a general decision on what your thesis is broken or not, if that makes sense. 

Mary: [00:35:51] So we want companies that are earnings upgrade cycle and the cycle part is important. So generally companies don't you know, this is a very important part of our investment philosophy. They don't miss once and then they're back off to the races where they don't beat once and then everything falls apart the next quarter. There's a lot of momentum in companies earnings, particularly some of these bigger companies. So generally what a lot of our quantitative backtesting shows is that once you're in an earnings upgrade cycle, you can stay in that cycle for quite some time. So Microsoft is a good example. It was in our portfolio for five and a half years before it went into an earnings downgrade cycle. So it's not you know, it's in the portfolio this quarter, it's out the next quarter. We're looking for stocks where you can see that longer term cycle. And I think Google is definitely in that longer term cycle now. The other thing to focus on, which we haven't mentioned yet is valuation. So one thing that I love about Google is that it's Google. It has the most amazing brand name in the world. It has YouTube, which is another amazing brand name. And for everything that you're getting for Google, you're getting that 19 times P and earnings growth for the next three years is 20% or higher. So you are getting a $1.7 trillion market cap company that's growing at 20% for a PEG of less than one times that that is like I mean that's very, very attractive. So taking a longer term view, you can always sort of come back to that valuation and say this is the bull case on the bear side. And when you even all those out, you're getting all that for 19 times. 

Alec: [00:37:12] Okay. So one thing, speaking of the, you know, the firehose of information we get every quarter from US earnings season, it feels like particularly in financial media, you see a real comparison on cloud growth rates between the three big players. AWS, Azure and Google Cloud and it's basically like the media just line up. There are three growth rates next to each other and say who's growing the fastest and who's growing the slowest? Is that what you guys do in Alphinity?

Mary: [00:37:41] No. We have a very detailed model. So my colleague Trent covers Microsoft and then I do Google and Amazon. There's a couple of things that you need to look at there. You can't just line them up. So one is AWS is way bigger, so is growing at 12% can be adding more dollars of cloud revenue than Azure growing at 25%. So we have a whole separate part of the spreadsheet that's looking at dollar ads and that's quite important. In the last quarter, AWS, even though it was growing at 12%, had the most dollar ads of cloud revenue of any of the Big three. So that's one way that we look at it. The second thing is back to our attenuating optimising, you know, we're looking at what is the direction and the direction of change for the for the global cloud players because you could have, you know, as you're growing at 25 plus percent, but if that's decelerating down to 24, that would be much, much worse than AWS growing at 12 and re accelerating up to, you know, 13, 14. So that rate of change is something that we look at. And then secondly, just recognising that rates have changed when you have AWS which is three times bigger than Google, they should be growing a lot faster because they're off a much, much smaller base. So recognising all those things, that sort of how we look at the cloud players and then we also look at whether there's any other cloud players that are coming up. So Oracle is a company which no one ever talked about in cloud for years and years and years. It has actually, you know, had some significant wins. So we you know, the big three are the focus. But you also need to look at what's happening more broadly in cloud, some of the restrictions coming out of China and the Alibaba cloud decision. And there's there's a lot going on in cloud besides the big three HYPERSCALERS. 

Alec: [00:39:13] So we've touched on a few different reasons to be concerned, but we should talk about the AI disruption risk because as much as your thesis right now is that they are going to be an AI winner, that is a thesis that I guess you have to keep challenging as new information comes to light. And the big concern a year ago was that no one would be Googling information anymore. We would be asking ChatGPT for that information. That certainly doesn't seem to have come to fruition. But there was no Yeah, well, that's I was going to say there would be people that just say it hasn't come to fruition yet. So how do you monitor that situation and how do you, I guess, assess what's happening? 

Mary: [00:39:56] One of the good things about ChatGPT and Bard is that you can test them yourself and come up with your own opinion. So we've done that internally and I personally think Bard is much better than ChatGPT. Okay. So the concern in the early days was because Bard hasn't come out yet. So you're comparing the amazingness and the excitement and the, you know, new product enthusiasm about chatGPT with nothing and in that, you know in that race obviously ChatGPT came out ahead but I actually respect the way that Google took its time in launching Bard because there are some significant risks to humanity if you if you get it wrong and Google they have had. I principals for years and years. They have, you know, sort of guardrails in place internally about how fast I can be developed. And I as a shareholder and one who cares about ESG and responsible development of technology, I appreciate that they didn't just launch it. And, you know, we'll deal with the consequences later. It was quite measured. And then when they did launch it, it's done quite well. So that integration into search and the use of part, I think so far is good. And as we discussed before, there was a few months there where Bing was gaining single digit market share and that's just reversed. So I think the early jury is saying that those two are doing okay. I think also it's a very good structure within Google, how they look at their lands and how they roll that out across their other products. Again, just highlighting openAI that's a very unstable structure. And I think Google, the fact that it's all in-house that has been in house since DeepMind and even even before that is a very favourable structure versus some of the other ones out there. 

Bryce: [00:41:32] Sidenote would love to do a podcast on the research of responsible AI that you're doing at some stage. So let's see.

Mary: [00:41:38] Yes. That report will be coming out in February, March. So happy to come back and discuss. We have. I'll just give you the like the teaser. We've engaged with over 30 companies globally. So about half of those are in Australia. And like the major companies in Australia and some of the biggest companies overseas. And I've learned a lot about AI full stop and I've learned a lot about how to approach responsible AI. So we're coming up with the framework so that even if someone's not an expert or if they're not a, you know, ESG expert, they can quickly look at a company and come to a decision about whether they think they're having a responsible approach or not. 

Alec: [00:42:12] So I think one last risk that we should talk about is just the legal risk. How do you assess the cases going on, the antitrust cases, but also how does it change your thesis if Google does get broken up? 

Mary: [00:42:27] I would say it's important to cast our minds back to the fact that the FTC and the regulators in the US have been going after big tech for quite some time now. So we discussed this with respect to all of them, whether it's Apple or Amazon, Microsoft, Google. The legal risk is not enough of a risk to not invest in these companies, because if that was your sort of stop gap, it's too risky. We're not investing. You wouldn't have invested in them for the last 15 years. One thing that's a little bit different right now is you have Lina Khan at the FTC, who is sort of on a warpath to break up big tech. It seems like right now her attention is mostly focussed on Amazon. And if you look at Amazon's business structure, there is a case to be made from an investor perspective, like from a value unlocking perspective and from a legal perspective, whether they use logistics and they use the different parts of their business to be anti-competitive, you know, there is some case there. So our view on Google is that the antitrust spotlight is shining on Amazon right now and that that will be the case for some time going forward. From a Google perspective, I guess it's not so much a Break-Up because unlike Amazon, there's less synergies that create antitrust problems between the different businesses. But within search, part of that lawsuit is that within search, they control both sides of the, you know, the buyers and the sellers. And that that is antitrust. So breaking up Google and saying YouTube has to be separate and search has to be separate and other. But to separate, that doesn't solve the problem of the fact that the potential antitrust issue is within one business. So I would say that the chances of Google being split up are slim. But obviously all of this legal risk is something that we're watching closely. And the rise of the Magnificent Seven in the last year, I think has probably highlighted this to regulators more because they are just so dominant. These seven companies and their market caps are so enormous that it's probably going to attract more attention than it has in the past.

Bryce: [00:44:16] So Mary, to close out then, if you think the probability of it being broken up are slim, what does Alphabet look like in ten years time? 

Mary: [00:44:26] So I'd say a few things. First of all, this is what I want it to look like. I want them to keep their moat in search. So I want that 90% market share and, you know, impenetrable moat around their core business to stay. I think that's the most important thing to making sure that the stock continues to perform. The second thing is, I want them to be a global leader in AI. So the debate that's happening now because it's early days in terms of which product is going to win, etc., etc., that debate is over and Google has been crowned at least one of the winners in globally AI. Thirdly, I want the cloud business to be much bigger. So it's growing fast. It's highly profitable, much more profitable than it is now, and it's a true competitor in the Hyperscalers with us in Azure. And then ideally, I'd like to still be attractively valued. So what you see with some of these companies that have very, very exciting stories is it gets priced in straight away and then it trades sideways over the next few years as people like are waiting for confirmation of what's happened. But Google, if you look at the history generally, that doesn't happen. If the valuation stays attractive and it continues to deliver on earnings in some of these more strategic things. And so it's a stock that you can hold in your portfolio for a very long period of time.

Bryce: [00:45:30] Awesome. 

Alec: [00:45:31] So what we didn't hear there is that we would be driving around in Waymo. Cause I would be taking drugs discovered by Alpha Fold, or that we'd be getting our drone deliveries from the wing. 

Mary: [00:45:41] I am very sceptical on other bets. So a few years ago, as you know, we've been discussing stocks for years and years. I was looking at Alibaba and Tencent and if you look at those two companies embedded in those companies, particularly in their heydays, was an entire super impressive VC business and they would just churn out these unicorns. You know, you'd get calls from brokers. There's a listing of a $25 billion stock in China, and Tencent is the biggest shareholder. And they were so impressive at investing in companies and then listing them and and generating returns from that. And if you look at other bets, they don't do that. I mean, we're, you know, decades into two other bets being, you know, that sort of investment and you have Waymo but it's unprofitable. It's basically rolled out in Phoenix and San Francisco, and they still have problems and they've tried many times to change management into like it's just it's not working. And then some of the other businesses, they sound interesting, like they're very interesting to look at, but they're not profitable either. And so other bets, when you put all that together, it's still loss making. And it's not just loss making. The losses are getting bigger year over year. That's not what I want to see. I want to see that like some sort of trend up to profitability. So maybe when if Ruth Porat goes to other bets and as her role as CIO can control that things can get better. But that would be a nice to have if it happens. It's not part of my underlying thesis. 

Alec: [00:47:01] Nice Love it. Well, it's a company we all are very familiar with and will keep using every day, so we'll be watching it closely And thanks for coming in and talking about it. 

Mary: [00:47:11] Great. Thank you so much for having me. 

Bryce: [00:47:12] Thank you, Mary.

Alec: [00:47:13] Now, before we leave, a huge thanks to our summer series partner CommSec, the home of investing. If you're looking for more support and resources to build confidence in the market, head to their content hub. Otherwise, you can get $0 brokerage on your first ten trades for Australian markets when you join five US dollar brokerage on American stocks and invest as little as $50 through the CommBank app. Download the CommBank App today or visit CommBank.com.au.

Bryce: [00:47:41] Stay with us because next episode we have Anna Milbe on unpacking Aurora pun intended and you'll find out why.