I published a comprehensive article about Alphabet’s other bets in January 2018 and explained that even with conservative estimates, the market is ignoring any possible positive free cash flow from those investments for the foreseeable future.
Since then, Alphabet made some significant announcements and posted better than expected earnings report, outrunning other FANG members. Despite a record-breaking $5 Billion fine imposed by EU and possible limitation on using Android as a promotion channel for its search engine, Google still outperformed Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and Netflix (NASDAQ:NFLX) over the last 30 days.
An essential item that didn’t grab the attention of the investment community is the first ever major upgrade to Google’s self-serving advertisement platform, Google AdWords. On June 23rd, 2018, Google officially announced the change to integrate different solutions under one brand, Google Ads.
I have been using Google Ads on a daily basis for more than ten years and so, have a deep understanding of how this tool works and what changes are coming. This is major news for investors, as I believe the new platform has the potential for moving a fundamental barrier that Google faced for years whenever it tried to grow revenue more than historical levels. Let’s start with a quick introduction on How Google makes money through Ads.
Pay Per Click Business Model
Whenever you click on an ad, Google charges that advertiser for that click; it’s called Cost Per Click or CPC. Therefore, Google’s revenue is equal to the number of clicks times CPC. CPC is not the only way Google charges advertiser, but it’s the dominant method. For the last five years, more than 70% of revenue generated by Google Properties which is mostly CPC based. This table shows the share of revenue for each segment over the last five years including two earnings reports for 2018:
Source: 10-K and 10-Q reports for Alphabets and Google, table prepared by the author
The only metrics that Google releases through quarterly and annual reports are changes in CPC and Clicks compared to previous periods for Google properties, partners and in aggregate. Starting with the first quarter of 2018, Google stopped publishing aggregate changes in CPC and Clicks and replaced the clicks and CPC data for partners with impression data. Impression indicates how many times an ad displayed, rather than clicked.
Let’s take a look at the Quarter by Quarter changes for each metrics. Changes in Clicks and CPC are in comparison to the same quarter of the previous year.
Source: 10-K and 10-Q reports for Alphabets and Google, table prepared by the author
The Relationship Between Clicks and CPC
I draw a graph to better demonstrate the relationship between changes in CPC and changes in Clicks over the past five years on an aggregate basis. A linear regression model fits well with a statistically significant p-value and F-Value at 99%. In other words, there’s a linear relationship between them; more negative changes in CPC translate to more positive changes in Clicks.
Source: 10-K and 10-Q reports for Alphabets and Google, graph prepared by the author using R and ggplot2 package
The blue line is a linear line fitted to the points. There’s a negative relationship between changes in CPC and changes in the number of clicks. Here are the parameters of this model:
Source: linear regression model prepared
This is a fundamental hurdle for Google on its way toward growing revenue.
This is a fundamental hurdle for Google on its way toward growing revenue. As mentioned earlier, Google’s revenue is equal to the number of clicks multiplied by CPC. Therefore, if they try to increase the number of clicks and it affects the CPC, the potential for revenue growth would be impeded. As a comparison, you can compare it to a traditional Demand curve saw in economics. Higher prices mean lower demand.
What would be the Solution?
We talked about the way Google makes money, but we didn’t get into details on how CPC is determined.
Before showing an ad, Google runs an auction among advertisers who are competing for that space, based on what you’re searching for. Bid, the amount of money each advertiser is willing to pay for each click, is just one of the several inputs to this process. It’s a sophisticated procedure, beyond the scope of this article. However, the most important thing you need to know about this process is that Google, run an auction EVERY TIME it shows an ad for every single visitor, for every search. That means billions of auctions every day!
Google, run an auction EVERY TIME it shows an ad for every single visitor, for every search. That means billions of auctions every day!
This auction is fundamentally different compared to a regular auction. The winner will only be charged at the second highest bid. So, if John and Mike bid $1.0 and $1.2 for users who are searching for “Best investment advisor” and assuming Mike win the auction, Google will only charge him $1.0 for each click.
Here’s a short video on how Google determines the winner and how much it would charge for CPC.
As I mentioned, besides the bid, several other parameters affect the bidding process and can potentially change the winner. Millions of advertisers are relying on Google for their advertisement, and they need to change the bid for every keyword they want to compete for, on a continuous basis. How many of them do you think to have the capability and resources required to do so?
How many of them do you think to have the capability and resources required to do so?
Google’s First Major Update
Since the launch of Google AdWords on October 23rd, 2000, Google made many changes to its platform, including new ad formats, new ad extensions, change in how ads appear in the search result, expanding the ads to AdSense and YouTube and so on. However, the base of the system never changed fundamentally, until July 2018!
On June 27, 2018, Google officially announced a significant change to its self-serving ad platform, renaming it from Google AdWords to Google Ads.
I believe investors should consider this change as a significant improvement to Google’s revenue growth potential because some of the tools and practices introduced, can fundamentally alter the CPC / Clicks relationship we analyzed. I’m presenting some of the most critical changes that are coming to Google Ads and how they’ll impact its growth potential.
Enhanced Campaign Creation Tool
The new platform provides a super simple, straightforward interface for creating a campaign. Let’s take a look at the old and new interface:
Google AdWords old interface; the first step in creating a new campaign
Google Ads new interface, it starts by asking about your goal
With the new interface, Google is moving from a technical and complicated interface toward a softer, more practical with a focus on “what users want to accomplish.”
In the next step, it used to ask you on the channel you want to use for advertisement:
Google Adwords old interface; Step 2, choosing campaign type
Google Ads new interface; Step 2 gives you a visual understanding on each channel.
When Google introduced its Self-serving platform 18 years ago, they were mostly targeting “Digital Marketing Professionals” with a deep technical background. With the growth of search ads, now Google is providing tools for the general public to run their own campaigns. They also started offering free phone support to anyone who wants to advertise.
In an auction, we expect people to gather, make their mind and submit a bid. They can change their bid based on the environment and their desire to win among other things. The Google’s auction, on the other hand, is entirely different. You don’t have information about other bids and this dynamics changes by the moment. As I mentioned earlier, every time someone uses Google to search for something, this auction runs, and there are winners and losers. Google has the upper hand here with asymmetrical access to information. The new platform goes one step further and by default, guides the advertisers to choose from a family of automated bidding strategies called “Smart Bidding”.
When you create a campaign, you tell Google what’s your desired outcome; you expect to receive a lead, sell a product, receive a phone call, a visit to your website or even an installation of your app. When someone uses Google to search, Google also has plenty of information about her: where’s she located, what type of device she’s using, whether she visited your website before or not, what language she speaks, and so on.
Using its sophisticated Artificial Intelligence, Google predicts how plausible is that this user will take your desired action upon clicking on your ad. May sounds sci-fi, but it’s exactly what Google is trying to do.
Based on this probability, Google adjusts the bid on your behalf to maximize your chance of receiving what you asked for, which can be a visit to your website or even outranking your competitors.
Now add the monopoly of Google to this equation. It has all the data it needs to optimize its own revenue, the most dominant search engine and the most advanced tool for generating revenue through search ads. What Warren Buffett calls economic moat!
It’s like you go to a car dealership and give your consent to the salesperson to sell you your desired car at a price he set. He knows everything about the car and your circumstance and then decides what should be the price you’re going to pay him to buy that car. Seems crazy, but it’s the bare truth!
Auto Ad Suggestions
Advertisers prepare the content of the ad and submit it to Google through Google Ads. In the Google’s terminology, it’s called Ad Copy. There are plenty of small advertisers who simply don’t have the capacity to prepare a convincing ad copy, to entice you to click and generate revenue for Google.
To solve this problem, Google introduced Auto-Ad Suggestions as part of the new platform. Now Google’ AI machine, write an ad for the advertiser and add it to their account for their review. By default, they have 14 days to either accept or reject these suggestions. After 14 days, Ads will start running.
Google is changing a widely used tool for excluding Mobile traffic, and it’s expected to increase mobile traffic for advertisers significantly; that’s the traffic generated by displaying ads inside mobile apps.
Take a look at a letter Google started sending to advertisers.
This change, at least in short-term, will increase the traffic and revenue for Google, until advertisers adjust their campaigns and limit their exposure to mobile traffic.
Google announced an extensive update to its self-serving Ad platform at the beginning of 2018 and is forcing users to move to the new platform by the end of the year. This is a significant development for investors because I believe the stable, linear relationship between changes in clicks and changes in CPC we had over the past few years will be changed in favor of Google. Now Google uses its sophisticated AI machine to update bids and write Ad for advertisers.
If you’re anxious about the lower than expected growth rate in the number of Netflix subscribers, the dark clouds over the future of Facebook and not so happy with Amazon’s revenue growth, It’s time to shift to Alphabet.
Even if Waymo doesn’t start serving US cities by the end of this year, Google cloud fail in attracting more businesses, or other moonshot projects fail in bringing in more money, Google’s new advertisement platform is promising an extraordinary potential for revenue growth over the upcoming quarters.
Disclosure: I am/we are long GOOGL.
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.
Additional disclosure: This article is merely a statement of my personal opinion based on my individual analysis and provided as is, with absolutely no guarantee of the accuracy of any data or information provided. Past performance is not indicative of future results. Investors should do their own due diligence before making any decision. The author is not an independent financial advisor.