Is Google's Business Model Under Threat?

Key takeaways

• Google parent company Alphabet has recorded their second slowest quarter of growth since 2013.
• Earnings per share missed analyst forecasts by 15.44% and has highlighted concerns over the future of advertising revenue as a business model.
• Ad spending is down due to the economic environment, but Apple’s recent updates are causing direct hits to the ad revenue for companies like Google, Meta and Snap.

Google’s parent company Alphabet has recorded their slowest growth since 2013, outside of the start of the covid pandemic. In addition to missing expectations for revenue growth, earnings per share were also 15.44% behind analysts forecasts.

With an earnings season that has been mostly good news so far, the announcement has raised major concerns about the core advertising business and saw the Alphabet stock price plummet almost 6% in pre-market trading.

It’s the latest piece of evidence pointing to a global slowdown in the advertising market as inflation is causing both business and consumers to cut back. Yes, we’re all sick of talking about it, but it looks like it’s not going anywhere anytime soon.

Less ad spending overall is a problem for Alphabet, but it's not their only problem. Sneaking up on them, and on many other companies whose business is based on ad revenue such as Meta, is Apple's ad network.

Apple made sweeping changes to their privacy settings in iOS 14, which has made it significantly harder for products like Facebook, Instagram and Google to track user data and deliver targeted advertising.

While this move was heralded as a win for privacy advocates, it’s also become clear that it has given Apple a major leg up in growing their own ads platform. But that’s probably just a happy accident.

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Alphabets Q3 results have spooked the market and raised concerns about Big Tech

The company’s revenue grew 6% in Q3 to hit $69.1 billion. Those might seem like pretty good numbers, but it represents a 30% missed against analysts expectations of 9% revenue growth.

Breaking down the different segments of the business, Search revenue missed the forecast of 8% revenue growth to notch a 4.2% increase, while YouTube revenue actually fell -2% against an expectation of 4.4% growth.

Earnings per share were at $1.06 for the quarter which was down significantly from (the admittedly very strong) Q3 in 2021. The figure was also a big drop from the $1.25 that Wall Street analysts had been forecasting.

While there are widespread concerns about a slowdown in the global ads market, chief financial officer Ruth Porat attributed the poor performance in large part due to the strong US dollar.

This has been a consistent problem for many US multinationals reporting this quarter. The U.S. dollar has gained big against most major currencies across the world. It means that revenue generated in foreign markets is worth less once it’s reported in US dollars.

£1 million made in the UK this time last year would have created headline revenue of around USD$1.4 million. Now that same £1 million would only add around USD$1.15 million to Alphabets bottom line.

With ongoing challenges across much of the rest of the world, it’s unlikely that we see any dramatic weakening of the US dollar in the short term.

Spotify and Snap also feeling the pinch on ad revenue

Alphabet isn't the only company who's seen a slowdown in ad revenue growth. Spotify released their latest results last night as well, announcing that their profit margins had narrowed due to a softening in the advertising market.

Spotify CEO Daniel Ek stated that this slowdown “Is an early indicator of the concerns businesses are having about the economy. We’re not concerned long term, but it’s definitely impacting us in the short term and it contributed to the gross margin hit that we had this quarter.”

The situation is even worse for Snapchat parent company Snap, who announced their slowest revenue growth since the company went public five years ago.

The figures were matched with highly negative commentary from the company, stating that the short term outlook would be “incredibly challenging” and that they would not be making a forward revenue forecast because of the difficulty of the situation.

They were punished by the markets with the stock crashing 25% overnight.

These results have also been weighing heavily on other Big Tech companies who are yet to announce their results. The biggest name to watch for will be Meta who announce their Q3 results after the market close today and also rely heavily on advertising for their revenue.

The growth of Apples ad network

A further threat to the advertising business model has been the targeted approach from Apple. The introduction of iOS 14’s privacy updates reportedly put a $10 billion dent in Meta’s ad revenue, effectively overnight.

The update has been sold as an improvement in privacy, but there’s some fine print. The change didn’t mean that Apple will no longer collect users data, but simply that they would no longer share it.

That means that they won’t share your sneaker preferences or favorite TV shows or plans to lose weight with Google, Meta, Snapchat or anyone else, but it doesn’t stop them targeting users with ads themselves.

This provides an Apple ad network with a massive competitive advantage over other advertisers and there are some analysts who are suggesting that Apple's ad revenue could grow to be worth $6 billion by 2025.

Just this week we’ve seen Apple court controversy in this space with the latest App Store Guidelines as part of iOS 16.1. The new guidelines state that “boosted” posts that can be purchased via an app have to use in-app purchase functionality.

This would mean that any ad spend made on apps like Facebook or Instagram would need to go through Apple, which would allow them to take a whopping 30% cut from any revenue generated this way.

Should Alphabet be worried?

With the headwinds mounting up, Alphabet has some concerns, at least in the short term. It’s clear that they’ve seen the writing on the wall for the ads business for a while, with a concerted effort being made to diversify their business away from purely ad revenue.

Cloud computing has been the biggest factor in this. That business unit has been growing strongly and continued that trend in Q3 with a 38% jump in revenue. The problem is that growth is expensive and the division made a net loss of $699 million for the quarter.

Not only is that an insane amount of money, it’s also worse than this time last year when it lost $644 million.

Over time we are likely to see Alphabet become more diversified away from advertising revenue, in a trend that’s probably going to be replicated across the industry. Meta has been looking for new ways to generate revenue for a while, and even companies like Snap are trying to implement premium subscriptions models into their business.

The challenges highlight the constant flux in the tech industry. There are always new disruptors entering the market and shifting power between the biggest companies in the industry. They all have billions of dollars at their disposal and access to the best talent in the world, making innovation not a likelihood, but a certainty.

For investors, that can make it tough to pick and choose investments. We just have to look at the fall from grace for some of tech’s darlings to see how difficult it can be. Snap is down -79% so far this year, Netflix -51%, Meta -59% and Spotify -54%.

Diversification has always been the name of the game in investing, and that’s particularly true in the tech sector. But the old methods of creating a set percentage based portfolio and then letting it sit forever don’t work so well anymore. The world moves faster.

That’s why we use AI to power our Investment Kits. We created the Emerging Tech Kit which uses AI to analyze thousands of data points and predict which parts of the tech sector are going to perform the best each week.

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