The Business Of

Eyeballs | Alphabet | What Are Their Margins?

Morning All!

So, yesterday we dug into how Alphabet makes money. And we saw that ~80% of the company’s revenue come from advertising. We saw that Google Search brings in the majority of the revenue. And we saw that Alphabet’s growth has been pretty mind-blowing. Revenues have grown from ~$3bn in 2004 to ~$307bn in 2023!

But anyway, that’s enough about revenues. Today, let’s switch our focus to margins and start by looking at how Alphabet’s cost structure is split…

We can see that a massive ~60% of Alphabet’s costs come under the ‘Cost of revenue’ bracket. But I’ve actually split up that ‘cost of revenue’ segment into 2 sub-segments - (i) cost of revenue - ex TAC (37% of costs), and (ii) cost of revenue - TAC (23% of costs).

So, the main question to ask is - what on Earth is TAC?! Well, that’s something we’re going to dive into right away!

The Amount Google Pay Apple Is More Than Spotify’s Entire Revenue…

Okay, so TAC. What does it stand for? Well, it stands for traffic acquisition costs. And I’m sure a follow-up question a lot of us have is - what on earth are traffic acquisition costs?!

Well, traffic acquisition costs are basically the amounts that Alphabet pay to companies to help bring traffic to Alphabet’s products - Google Search, Google Display Network, and YouTube. We’ll focus on Search in this section.

Now, what do I mean exactly? Well, you know when you want to quickly ‘Google something’ on your phone. What do you do? You open up your iPhone. You click ‘Safari’. And you type your query into the search bar. Did you actually type ‘google.com’ anywhere? No you didn’t! Google Search just appeared as your default search engine!

So the question is - do phone manufacturers like Apple, Samsung, etc. pick Google Search as their default search engine (over Bing, Yahoo, etc) out of the kindness of their hearts? Well, the answer is of course not! Alphabet have to pay Apple, Samsung, and other phone manufacturers so they’ll make Google Search their default search engine!

And the headline below shows us that these payments aren’t small. In 2021, Google paid out an extraordinary ~$26 billion to become the default search engine on web browsers and mobile phones!

By the way, this is very similar to what we saw in The Business Of Netflix. We’ve all seen the Netflix button on our remote controls. But do TV companies put that on for free? No! Netflix have to pay the TV companies for that favour!

Okay so, the question here is - where do all of Google’s traffic acquisition payments go? Which company is benefitting the most? Well, the answer probably doesn’t come as much of a surprise. It’s the largest phone manufacturer in the world - Apple!

Now, how much do Alphabet pay Apple alone? Well, it is reported to be a quite extraordinary ~$18 billion! $18 BILLION! That’s more than Spotify’s total revenue! Madness!

But the point I want to be really clear on is WHY are Alphabet doing this? Why are Alphabet paying Apple ~$18 billion a year? Well, the answer is traffic. Alphabet need traffic going to Google Search. Because what does traffic mean? Traffic = advertising revenue! More traffic = more people searching for things = more money Alphabet will get from advertisers! And the graphic below should help us here.

And Apple are incredibly vital in this equation. There are ~1.5 billion people in the world who use iPhones. And quite incredibly, >50% of Google Searches are done from Apple devices (iPhones, Macs) every year!

Now, imagine if Alphabet decided to stop paying Apple for this default search engine position. And let’s say Apple used Microsoft’s Bing instead. What would happen to Google Search’s traffic? It would most definitely go down - as a lot of people would just use Bing instead! And what would happen to Google Search’s revenue? It would also go down - as advertisers would find Google Search less valuable!

‘MrBeast - Here’s Some Money… Please Keep Bringing In The Views!’

Alrighty, so that’s a good breakdown of the traffic acquisition costs we see for Google Search. But what about the TAC for YouTube and Google Display Network? Well, let’s start with YouTube first.

And similar to Google Search, what do Alphabet want? Traffic! They want people coming onto YouTube to watch lots of videos, because this makes YouTube valuable for advertisers! And this in turn means advertisers will pay them more to advertise. The image below shows us an example of Shopify advertising on one of MrBeast’s latest videos!

Now for Google Search, we saw that Alphabet rely a lot of Apple to help them bring in that traffic. But in the case of YouTube, it’s not huge companies like Apple that Alphabet pay to bring in traffic. It’s mainly people! Creators like MrBeast (~240m subscribers) and PewDiePie (~111m). Millions of people around the world love watching their videos. And where do they go to watch these videos? YouTube!

And in order to incentivise creators like MrBeast to continue creating lots of great content on YouTube, and bring in all his traffic, what do YouTube do? Well, they pay them! And pretty handsomely too. According to this research, MrBeast makes an astonishing >$2 million/month from YouTube paying him for his views!

But here’s a question. Do YouTube really need to pay popular creators to post on their platform? TikTok and X (Twitter) have started doing a similar thing. But Meta’s products - Instagram and Facebook - don’t pay creators for posting and bringing in traffic. So, do YouTube really need to do this?

Well, we’ll dive into this more next time when we look at The Business of Meta. And figure out why YouTube pays creators… but Mark Zuckerberg doesn’t!

Okay, final thing on TAC. And that’s Google’s Display Network. And we’ll keep it brief as it’s similar to YouTube. In the graphic below, we can see the screenshot of the Daily Mail webpage with a display ad from Singapore Airlines. As we saw yesterday, Alphabet will make money from this ad through impressions (as people view it).

But who’s actually bringing in the traffic to the web page? It’s not Google… it’s the Daily Mail! And so like with MrBeast, Alphabet pay their network partners (like Daily Mail) for bringing in the traffic!

Warehouses Full Of Thousands Of Computers POWER Google!

Okay great, so that’s a good look at the costs Alphabet pay to companies/creators for helping bring traffic to their products. But there’s another big ‘cost of revenues’ for Alphabet. And that’s their data centers. The image below shows us Alphabet’s massive data center in the Netherlands - one of their 24 global data centers.

Now, first question - I hear this term ‘data center’ a lot - but what exactly are data centers?! Well, Alphabet's data centers are like massive, high-tech warehouses filled with hundreds of thousands of computers (servers)! These computers store and process all the DATA needed for Alphabet’s services - including Google Search and YouTube. So, when we search for something on Google or watch a video on YouTube, it's all happening thanks to the 24 data centers working behind the scenes!

Okay, so we know these data centers are pretty important! But second question - what are the costs for Alphabet here? Well firstly, the cost of buying the land and constructing these buildings is fairly high. But also, a huge part of the cost is all the infrastructure that’s inside these data centers. And by infrastructure I mean, (i) the computers (servers) - to handle all the Google queries, (ii) the routers, cables, switches - to connect all the computers, and (iii) cooling systems - to prevent the servers from overheating! The image below shows us what the inside of one of Google’s data centers - it’s just racks and racks of computers!

And remember, the reason Alphabet need all these computers is because over 4 trillion Google Searches are being done a year! And how long does it take for Google Search to give us the results to our queries? Less than a second! And the reason it’s so fast, is because of all these computers they have! This video here gives you a more in-depth view of the power of data centers.

Alrighty, let’s move on - we’ll come back to data centers tomorrow! We’ve looked at the costs for Alphabet to ACQUIRE users to their services (Apple, MrBeast, Daily Mail). And we’ve looked at the costs for Alphabet to POWER their services (data centers). Now, in the chart below, we can see how these costs translate into gross margin. And it’s a pretty amazing sight. Alphabet’s gross margin has been incredibly high consistent over the years!

Want To Be Rich? Become A Investment Banker Google Software Engineer!

Okay, so we’ve looked at ‘cost of revenues’. But there’s one other major cost for Alphabet to run their business. And that’s people! The tech giant employs a whopping ~182k people across the globe. And as you can see from this link, there are 9 main teams that these people are segmented into - engineering, sales, marketing, design, strategy, finance, legal, people, and facilities!

Now, as you can imagine, the average salary for an Alphabet employee is pretty decent. In fact, Alphabet rank 2nd in the world (for companies >25 employees) when it comes to the highest median salary for employees! The median employee at Alphabet gets paid an astonishing ~$280,000! Meta - the company we’ll be looking at next in TBO - is first with a median salary of ~$300k!

Now, if we took a ‘mean’ average and included bonuses, this $280k figure would be even higher! But let’s stick with $280k for now. So, how much do Alphabet pay in total for salaries? Well, it’s a staggering ~$51 BILLION ($280k x 182k employees)! 51 billion on salaries - incredible!

But here’s a question - are there particular teams that get paid the most? And the answer is yes! A huge part of this salary bill will be going to the ~27k software engineers Alphabet employ around the world! As you can see from the headline below, Alphabet’s engineers are among the best paid employees in world - earning considerably more than $300k per year!

Now, why do Alphabet need so many engineers? And why are their salaries so incredibly high? Well, the answer - from a business angle - is because there’s a huge demand for software engineers. And when demand is higher than supply, what happens? Prices (in this case, salaries) go up!

However, from a technical angle - I recommend checking out this video. Which explains the kinds of problems Alphabet’s engineers work on daily. And how detailed these problems are. Because then, we’ll be able to grasp why companies like Alphabet and Microsoft need so many of them!

Hmm… Good But Not Great?

Alrighty, time to wrap up! We’ve had a good look at Alphabet’s main costs - TAC, data centers, and people. Now it’s time to see how Alphabet’s EBIT margin has coped with all these costs!

And as we can see from the chart below, it’s a pretty pleasant sight! Like with the company’s gross margin, Alphabet’s EBIT margin has stayed high and consistent over the last 2 decades - never dropping below 20% in a given year!

Now, of course, 27% is a fantastic EBIT margin for any normal company to have. But some of us may be feeling a little let down with this 27% for Alphabet. Because Alphabet isn’t just any normal company! It’s Alphabet for crying out loud!

On TBO, we’ve seen TSMC with a 50% EBIT margin. McDonald’s with a 40% margin. Nvidia with a 37% margin. So, what about Alphabet? Why aren’t they in these upper echelons of EBIT margin? Well, it’s a good question and it’s something we’ll be diving into tomorrow!

28th Feb 2024

Nigel Jacob CFA