Google Searches for Ad Market Domination

With a dominant Internet search product as its foundation,

As consumers use multiple devices in a post-PC world, these changing behaviors shine a light on other successful products Google has built in order to keep a hold on users and provide a greater benefit to advertisers. Google's mobile operating system and browser help to unify users' experience as they move from one device to another. The firm's success in products such as Gmail, the Chrome browser, and Google Maps provides a cohesive experience for users and helps Google show more relevant ads.

Our general thesis for the online media sector assumes that digital ad spending will continue to consolidate around companies with unique assets and reach, such as Google and Facebook FB. A strong secular growth trend for online advertising is core to our thesis. The market for Internet search advertising is still growing in the double digits, while display advertising is growing thanks to newer innovations tying display ads to specific actions, including clicks, leads, and customers. Faster-growing geographies such as Asia are propping up overall growth rates even as pockets of economic weakness hit various regions.

As the pre-eminent leader in search, Google maintains more than 60% of worldwide market share; no other competitor has even 10%. We believe the company's early technical advantages attracted users who now use it habitually, creating a switching cost based on familiarity with the engine. Although we expect small movements in market share, we believe Google's dominance will persist and not lose more than 3-5 points of share.

Investors should be aware that new businesses and products are unlikely to be as profitable as the desktop search market, however. As Google will be forced to share payments with other players in the value chain, such as content owners, application developers, and handset makers, profit growth may ultimately lag revenue growth over the long run.

Technological Supremacy Continues We believe technology rarely creates sustainable competitive advantages, but we would be remiss not to recognize that Google's dominance in search was initially driven by superior technology, and this supremacy has continued. More Internet searches are performed on Google's servers than all other search engines combined, even as the competition has narrowed that technological advantage. In our view, consumers are accustomed to using Google, and their habits reinforce the firm's moat. While the industry may not exhibit traditional switching costs, users may see little to no benefit in abandoning Google. Furthermore, the company can closely monitor clicks by every user to enhance the user experience. We would be surprised if the firm were to experience a dramatic loss of market share in search.

Google has aggressively invested its cash flow in new areas, including its Android operating system for smartphones and tablets. More than 500 million Android devices are in customers' hands. Although Google does not earn any direct revenue from licensing Android to handset providers or from the sale of applications, having Google software on the phone helps to ensure that when users search, they use Google. We estimate that about 90% of mobile searches are performed on Google. Additionally, the firm runs a mobile ad display network, AdMob, which helps Google, application providers, and wireless carriers capture a piece of the growing online advertising market. By providing Android free of any license fees, Google has provided the entire ecosystem an alternative to Apple's iPhone and iPad. We estimate Google's mobile revenue including Google Play content and applications exceeded $12 billion in 2014.

We do not believe potential regulation will neutralize Google's existing competitive advantages, and a recent ruling by the Federal Trade Commission seems to support our stance. In our view, the genesis of lobbyists and politicians pushing for regulatory intervention is Google's dominant position. However, it is not clear that consumers are being harmed, and it's difficult to envision new regulations that would level the playing field. Advertisers will continue to choose outlets where they get the biggest bang for their buck in terms of access to audience, reporting and analytics, and return on investment.

Potential Issues for the Wide Moat We expect the company to remain the dominant provider in Internet search on PCs, tablets, and handsets. As the Internet is still a disruptive force, however, we are closely watching several issues.

The launch of Facebook's Graph Search is significant, although the impact of social activity on the Internet is nascent and not fully understood. We do not believe Graph Search is a transformative product, simply because we don't expect users to abandon Googling in favor of Graph Searching. We believe that Internet search is good enough for most, and innovation is likely to be incremental. Furthermore, Internet searching habits are largely ingrained. The combination of these factors represents switching costs that we believe are easy to underestimate.

Facebook and Twitter TWTR are not only capturing users' time, but also grabbing information about them. Obviously, advertisers go where the users are, and the information about those users is valuable. Still, we are not seeing much evidence that these social networks are affecting search behavior. Instead, we believe companies that rely on display advertising are more vulnerable. In display, we do not believe Google has a moat, despite our prediction for strong revenue growth. Social networks may take the lead in the display market, but we believe this activity accelerates the shift of ad spending online and ultimately will benefit Google as well. Still, we plan to follow Facebook's efforts to diversify into search with great interest.

Mobile advertising and search is potentially disruptive, and with Android, Google has made sure that not only does it have a seat at the table, it's at the head table. For Google, market share in the mobile industry is not only key to maintaining its core markets; it also provides great avenues to future revenue opportunities, including mobile payments and local deals. Both of these initiatives are being explored and tested.

Although we believe Internet search is habitual, explicit switching costs are relatively low. Fickle consumers may move to a competitor that is able to establish a stronger brand or a more useful experience. Google is investing in new businesses where it is less competitive, which may lead to a deterioration in its operating margin and return on capital. Advertisers may find new ways to reach their target audience in a cost-effective manner, like Facebook. Finally, competition in technology is fierce, and employee retention may become more difficult and cause an increase in operating costs.

CFO's Retiring, but Investors Should Stick Around Cofounder Larry Page was named CEO in April 2011, taking over from Eric Schmidt, who had been CEO since 2001. Schmidt's tenure saw Google define its business model, become a public company, and stay at the forefront of the Internet advertising industry as the largest company by revenue and enterprise value. Schmidt retains his position as chairman of the board and has a more active role in lobbying Washington. Google essentially has been managed by a three-person team of Schmidt, Page, and cofounder Sergey Brin. The company's equity has a dual-class structure that concentrates the voting power in the hands of these three executives, who hold two thirds of the voting rights. They also have a significant economic interest in the firm at more than 15%, which helps to align the interests of management with the shareholders.

The company is expected to announce a transitional plan for a new CFO by the third quarter, as Patrick Pichette has announced his intent to retire. We believe Pichette has been instrumental in creating a milestone-oriented approach for the firm's capital investments, although we acknowledge Google has not generally improved its transparency. Still, we believe that the company recognizes the importance of this role, and we continue to expect financial discipline will eventually help to generate operating leverage over the next couple of years.

Generally, we are encouraged by management's long-term focus on capital allocation, although the lack of transparency around milestones for new projects presents an analytic challenge. We are encouraged that past acquisitions including DoubleClick, Android, and YouTube are bearing fruit and deepening the company's moat. Additionally, the management has been pruning products that have not been hitting internal success metrics--a positive development, in our view. The company reached an agreement to sell Motorola's home business to Arris, another positive development, as we did not believe the segment generated excess returns and it also had no strategic benefit.