ALPHABET’S FUTURE GROWTH

SCOTTISH MORTGAGE INVESTMENT TRUST

Tom Slater, Investment Manager. Fourth Quarter 2018 – Alphabet’s Future Growth Baillie Gifford

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Alphabet Future Growth 36587 1218.indd Ref: 36587 IND AR 0512 Fourth Quarter 2018

ALPHABET’S FUTURE GROWTH

BY TOM SLATER

This year marks a decade since we first invested in Google for Scottish Mortgage Investment Trust clients. Its market capitalisation was around $200 billion at the time. Today, it has a new name and is of course worth much more.

3 – Alphabet’s Future Growth

...Alphabet has scaled its Precedent suggests that making significant returns from a market revenues significantly faster capitalisation of $750 billion is improbable. Research on complex than its headcount. adaptive systems by Geoffrey West and his colleagues at the Santa Fe Institute suggests that as an organisation increases in size its output grows more slowly than it does. Support for this contention can be We know this intuitively as ‘growth of seen in the low headcount and physical bureaucracy’ or, more articulately, the infrastructure relative to revenue that 2016 shareholder letter from Amazon’s these businesses exhibit. Over the CEO Jeff Bezos suggesting that past 10 years, Alphabet has scaled its “Day 2 is death”. Similarly, complex revenues significantly faster than its systems analysis puts forward the headcount. This is a strong argument concept of organisation metabolism: for its ability to break through the in plain English, the idea that the empirical difficulties of growing output of an organisation is a function decisively beyond its current market of the energy that goes into it. As it capitalisation, however it is important scales, you have to put more energy in to consider what will be the drivers of for each unit of output – just as is true growth from this point. of biological organisms. The potential upside for Scottish Could it be that some of the large Mortgage’s investment in Alphabet platform businesses defy this has two parts. efficiency decline because they aren’t —— First, the core business is more the only ones putting energy into their nascent than $90 billion of annual platforms? The way they facilitate advertising revenue suggests. interactions between members of their Conventional models of the ecosystems perhaps makes them less market opportunity in advertising like traditional corporations and more are rooted in the past and fail to akin to cities, whose output grows capture the recursive impact of more quickly as they scale. Alphabet and Facebook: these companies and their products are redefining the opportunity set. To value Alphabet in terms of current advertising spend would be akin to valuing Uber or Lyft based on the current taxi industry. —— Second, the technology that powers search is at the heart of many other technological developments, opening up new markets for Alphabet to monetise 4 in ways other than advertising. Fourth Quarter 2018

but those adverts also become more helpful to us. More broadly, as search results improve, the definition of PART 1: THERE IS advertising expands. In reality an advert is a proxy – users don’t want to see it and advertisers don’t want MUCH FURTHER TO to pay for it. Rather, both are seeking a transaction and as personalisation improves Google will be closer to GO IN ADVERTISING facilitating this.

The movement of economic activity online is a powerful force for Alphabet, but counterintuitively, it may be offline where Alphabet’s Online advertising is exploiting a of search as becoming everyone’s actions have the greatest impact. It is new opportunity. Digital advertising personal assistant? Consider the rapidly improving its measurement of grew from $118 billion in 2013 to product evolution from suggested activity in the ‘real’ world, including $206 billion in 2017. Yet, ‘blue links’ of 10 years ago to the Store Visits programme, an astonishingly (to me at least), other Google Home which responds to attempt to match users viewing an forms of media combined grew voice queries. This demonstrates the online advert to a completed in-store over the same period by $23 billion, changing consumer conception of transaction. This now has thousands rather than being displaced by online search. Internally, Google engineers of customers and 5 billion store advertising. If you believe this is a look at ‘headroom’, defined as the visits were tracked across 2016. new market then it makes sense to list of searches where results are Demonstrating the link between search think in terms of consumer use cases. poor. That list is growing rather than activity and offline purchases provides What does search do well and what shrinking because users’ expectations a powerful signal of the value of does it do poorly? are rising faster than search search advertising and should increase improvements. Users often refine their the price that offline businesses are As internet connectivity grows, search queries and, whilst they are prepared to pay for search keywords. more people are searching and are prepared to do that today, it does send doing so with greater frequency. This a fairly direct message that the service The use cases for search are volume growth creates untapped is not doing a good enough job. This growing. The quality of the product opportunities. The impetus from will change, but the future expansion is improving. The quality of the mobile remains huge yet there is much in use cases for search is evident. advertisements is improving. room for improvement in the mobile Advertising customers are driven by experience. As a greater volume and One response to this is greater return on investment and if you keep proportion of search is done on mobile personalisation. Often search doesn’t delivering this at greater scale, they devices, the expected improvement in take advantage of the many things will keep spending – indeed Google’s speed and quality of the mobile web it knows about you when delivering unspoken operating model revolves will be a significant positive. Alphabet results. This is beginning to change, around the aim of driving 20% growth is not merely a passive beneficiary, as initially with geographic location, but in the core business, decade after initiatives such as Accelerated Mobile with assets like Gmail and calendar decade. There is, therefore, no need to Pages – an open-source website (as well as your entire search history) frame the opportunity in terms of the publishing technology designed to at its disposal, Alphabet should current advertising market – Alphabet improve web content – are driving continue to improve our experience. is changing the game. these improvements. As the product gets better we will use it more. This not only creates more Search is not just accelerating, but opportunities to serve us adverts also changing, and becoming more 5 complex. What if one conceives – Alphabet’s Future Growth

PART 2: NEW SOURCES OF REVENUE

Put simply, the technology that powers search is opening up new markets that can be monetised through means other than advertising. Alphabet is famously a prolific investor in interesting ideas of all sorts, but some of its more immediate opportunities include X, Cloud and Waymo.

X CLOUD X is intended to develop new Alphabet entities Amazon Web Services (AWS) has anticipated or create value for other parts of Alphabet. It is Alphabet’s emergence as a serious player in the responsible for the deep learning research team enterprise cloud computing space for most of the Google Brain, life sciences unit Verily, and self- last decade, and it is only in the past three years driving technology company Waymo. X focuses that Alphabet’s cloud proposition has emerged. on projects with three characteristics – they must Alphabet’s slow start, plus AWS’ leading address a huge problem ‘for the world’, where market share gives Amazon some substantial there is a radical proposed solution, and a hard advantages. Microsoft’s Azure platform benefits technology aspect that makes it almost seem from the strong incumbency position that crazy to attempt that solution. Microsoft has in many enterprises. However this is an opportunity that is large enough to make a The rationale for taking on such projects is difference to Alphabet. Its efforts are supported that the impact of being successful is higher by Gmail and Google Docs which present a and the timeframes are longer. This structure viable alternative to Microsoft’s productivity allows Alphabet to attempt projects that tools, along with its unrivalled expertise in would be ruled out on the basis of time, risk, computation. or money elsewhere – and may mean it has less competition. The starting point is Google Cloud as a distant number three: recent results show a $4 billion revenue run rate which compares to AWS’ $20 billion. However, the market potential is large and growth rates across the sector are high. Assuming a 10% share of a potential $1 trillion market at 10% margins (given Alphabet’s relative position), this is potentially $10 billion of profits and $150 billion of value. 6 Fourth Quarter 2018

© Waymo

WAYMO Alphabet has cars on the street today with no-one software business, with the product sold by the in the front seats. No-one else does. Our intuition mile. Again this is important enough to make a on whether others are close is deceptive because real difference for Alphabet. the improvement from 99.999% to 99.9999% accuracy – while imperceptible – requires a There is still work to do from a technology ten-fold reduction in the algorithm’s error rate. viewpoint and to move pricing to an acceptable Two decades ago Carnegie Mellon students level for widespread adoption. However, it programmed a vehicle to cross the United States doesn’t seem to require anything revolutionary which drove autonomously for 98% of the or innovative to get us to an autonomous global journey. It is the final fractions of a percentage transport system – only more data and more point that are hard to achieve. computing power, two things we can be certain Moore’s law will provide. Waymo could potentially become the operating system for our transportation network. There are 1 billion passenger cars in use globally and approximately 300 million commercial vehicles. It is not unreasonable to assume 100% penetration of self-driving capability within Alphabet has cars on the street twenty years, assuming $100 per vehicle per annum for the algorithm translates into a today with no-one in the front $130 billion recurring revenue opportunity. It is also still quite possible that this is a winner- seats. No-one else does. takes-all market. Essentially a software business, margins could be 50%. Revenue and profit may be much higher if it is viewed as a hardware and

7 – Alphabet’s Future Growth

CULTURAL CONCERNS

My interpretation of the history of technology internationally it is a different story. In particular companies is that very strong franchises Alphabet’s relationship with European regulators that have faltered, or lost their place in the is concerning. The fines are significant, though pecking order, have seen their relevance in the context of Alphabet’s revenues the market decline as user preferences move away from has shrugged them off. More worrying is the their core competences. Examples include requirements the rulings impose on the business IBM’s eventually irrelevant dominance of and potential precedent it sets for other markets the mainframe market, Microsoft’s failure to – there are far more countries with competition adapt to mobile, or Nokia’s failure to produce a law that is similar to the EU than the US. smartphone. While Alphabet’s dominance may end because the market moves away from it in Culture may also be the principal barrier to a way which isn’t currently obvious, the biggest expansion in new growth categories. Chris threat to Alphabet today is Alphabet. Perhaps Urmson, the erstwhile head of Waymo, was visible from the outset, its culture is one of fascinating on this. He saw the biggest barrier intense intellectual competition, where pride is to Alphabet achieving scale in self-driving taken in intellectual superiority and Googlers are vehicles not as a technical hurdle, but rather seen as the smartest in the room. There is some an inability to access a vehicle platform. On justification for this arrogance – the world’s best the surface this seems absurd since Alphabet’s computer scientists work at Google. The people cash pile would be sufficient to buy it much of from the core search operations are the smartest the world’s automotive production capacity. that I have come across in the Valley and they His point was that while the large players in have arguably built the most powerful business the automotive industry are keen for a partner, model in history. But this culture can leave the Alphabet wants suppliers of ‘dumb’ vehicles company blind in other ways. as conduits for its sophisticated technology. Unless that cultural dissonance can be addressed, It is true that Alphabet is much savvier today progress will be slow. This also manifests in interactions with the outside world than has in Cloud, where Alphabet has always had a been the case in the past. However, as I see theoretically strong position, but ‘Enterprise’ it, this does not represent a genuine attempt was, for many years, not seen as a worthwhile at engagement with government and society. undertaking. Since then Diane Greene has made Rather it is a preventative barrier – simply a much progress as CEO of the Cloud business – way to keep government officials as far away but surely any competitive edge has to come from Mountain View as possible. This strategy out of harnessing the technical prowess of the seems to have worked in the US so far, but wider group.

8 Fourth Quarter 2018

9 – Alphabet’s Future Growth

DOES THIS STOCK HAVE THE POTENTIAL TO BE A REAL OUTLIER?

The Alphabet investment case looks very solid and the THE BASE CASE core search business could deliver 20% growth for the next decade. This is the best core business we have ever seen, The advertising business is made up of Desktop, Mobile, and after a decade of ownership there remains much to go Display Network and YouTube. Desktop is growing more for in search and advertising. Cloud and Waymo also have slowly than Mobile but carries a lower traffic acquisition the potential to contribute significantly to the company’s cost, so is higher margin. This would suggest a blended overall growth. From this starting point, Alphabet looks growth rate of 23% for the next five years, taking operating very appealing, particularly as the 20% growth profile profits from circa $27 billion to about $62 billion. What appears underappreciated. is a net profit stream of $49 billion growing at just under 20% worth? On this I would conservatively assume a multiple of 25 times. Then, add the $100 billion presently on the balance sheet to the $200 billion the company would generate over the next five years, and this takes you to $1.5 trillion of equity value. Assuming $150 billion for Cloud This is the best (as a 75% chance) and $1 trillion for autonomous cars (as a 10% chance), results in a value of $1.75 trillion. Including core business we in a further $150 billion for everything (!) else (Google Play has circa $11 billion of revenues and 50% margins, have ever seen, Verily, X, Nest, DeepMind, CapitalG, Venture) results in a return of two and a half times. and after a decade of ownership there remains much to go for in search and advertising.

10 Fourth Quarter 2018

ABOUT THE AUTHOR THE BLUE SKY CASE The five times return that we look for in our ‘blue sky’ scenario requires $3.7 trillion of capitalisation. The starting point for this ought to be an acceleration in the core search business. As Mobile becomes a larger part of the mix, growth could accelerate. At the same time, the penetration of Android and the growth of Alphabet may improve profitability as traffic acquisition costs could fall. On that basis we could be looking at $84 billion in operating profits in five years time, growing at 30%. The most powerful monopoly on earth, with impressive growth, would surely be worth nearer a multiple of 40 times – giving us $2.6 trillion of value. The undiscounted worth of Cloud and autonomous driving provides enough to get us to a five times return without considering the value TOM SLATER of the other ‘moonshots’. Investment Manager

When considering the upside for Alphabet, it is Tom graduated BSc in Computer interesting to note that when, in 2010, I outlined Science with Mathematics from the a scenario with a market capitalisation of $1 University of Edinburgh in 2000. He trillion we felt it was ‘punchy’. Yet we also felt joined Baillie Gifford the same year that the downside seemed fairly limited; we and worked in the Developed Asia and feel similarly relaxed today. However the key UK Equity teams before joining the consideration as to whether we have a sufficient Long Term Global Growth Team at chance of making a profit from this point lies in the start of 2009. Tom became a Alphabet’s culture. Partner in the firm in 2012. Tom was appointed Joint Manager of Scottish Mortgage Investment Trust in January 2015 having served as Deputy Manager for the previous five years. In 2015 Tom was appointed Head of the US Equities Team and is a decision maker on Long Term Global Growth portfolios. Tom’s investment interest is focused on high growth companies both in listed equity markets and as an investor in private companies.

11 CURIOUS ABOUT THE WORLD

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