Where Alphabet’s Growth came from in Q4 2016

Alphabet reported its financial results for Q4 2016 last week and posted very healthy year on year growth of 22%, its strongest growth since 2013, and far higher than its average growth from 2014-2015 of 12%. For Insiders today, I thought I’d dive a little into where that growth actually came from, with a view to seeing what it tells us about how Alphabet might grow in the future.

Where Alphabet’s Revenue Comes From

The best starting point for this analysis is looking at where Alphabet’s total revenue comes from. The pie chart below shows the split between four categories in Q4:

Those four categories are:

  • Ad revenue from Google’s own websites, including everything from Google.com to YouTube to Gmail
  • Ad revenue from Google Network Members’ sites, which is all the non-Google sites it serves ads on
  • Other Google revenues, which are all non-ad revenues in the Google segment, including revenue from Google Play, enterprise cloud services, and hardware
  • Other Bets, which is all the revenue that comes from non-Google subsidiaries of Alphabet.

As you can see, Google’s revenues are 99% of the total and Google ad revenue contributes around 86% of Alphabet’s revenues. That second percentage was as high as 97% a little over five years ago, so things have changed considerably, but it’s still fair to say that both Alphabet and Google’s revenues are dominated by ads.

What Grew Over the Past Year

Other Bets – growing fast from a tiny base (and losing lots of money)

The growth rates of these various businesses are very different, however, so it’s worth looking at how the composition has changed over time. The fastest-growing segment is also the smallest: Other Bets. That segment grew by 74% year on year but, of course, the actual numbers involved are very small – that was growth of just $111 million over last year’s fourth quarter. Alphabet doesn’t break out the details here at all, except to say (as it has in the past) that the only subsidiaries within Other Bets that generate meaningful revenue are Nest, Verily, and Google Fiber.

Management did talk up Nest growth but only during a very narrow window around Thanksgiving, so there’s a good chance Nest contributed some of the overall growth but it’s impossible to know how much. It’s also worth noting the Other Bets collectively continue to lose money hand over fist, though the scale of the losses in margin terms has shrunk ever so slightly.

Google Other – Play and Cloud Get a Boost from Hardware

The next-fastest rate of growth came in the Google Other segment, which grew 62% year on year. This is one of the most interesting aspects of Alphabet’s results this quarter because it’s where Google’s new first party hardware, such as the Pixel and Home, sit. That segment had been growing by between $400 and $700 million year on year before Q4, driven by a combination of stronger Google Play app and content sales and Google’s enterprise cloud business. Again, the company has given very little insight into how big each of those businesses is or how fast each is growing but the run rate gives us some sense of what hardware might have contributed. That run rate for Play and Cloud has been accelerating, so I’ve estimated it likely accounted for $600-700 million of the $1.3 billion in year on year growth in Google Other. As such, the other $600-700 million of growth came from hardware sales. Within that, of course, there’s Pixel, Home, Google Wifi, and Daydream View but there’s a good chance much of it came from Pixel sales, which had by far the highest average selling price, likely around $700. I estimate Google sold 600-700,000 Pixel devices along with a similar number in total of the other three categories. That’s not bad for a first quarter, especially given the fairly limited distribution and apparent supply constraints but, of course, it’s a blip in the overall smartphone market.

Google Ad Revenues – Google Sites Vastly Outpacing Third Party Sites

Let’s turn to Google’s ad revenue, which grew by 17% year on year overall but was made up of those two distinct buckets: Google’s own sites and third party sites. Of these two, Google’s own sites grew far faster, at 20% year on year relative to just 7% for third party sites, though that 7% was well up on the recent rate of growth for this segment, which has been 1-3%. That’s been the picture for some time now, with Google’s own sites driving the vast majority of overall ad growth for Google, while third party sites barely grow at all. The underlying ad metrics Google provides show why this is: the price per click across Google’s own and third party sites has been falling pretty consistently, the number of clicks on third party sites has been essentially flat, and clicks on Google’s own sites has been rising somewhat. In other words, falling prices and almost stagnant traffic have been responsible for the flatlining of the third party business and it’s only rapidly growing clicks on Google’s own sites that have driven growth.

What, is responsible for these trends? Well, it comes down to three things: the transition from desktop to mobile, the growth of YouTube, and Google’s increasing presence in programmatic advertising. The transition from desktop to mobile means traffic is going from desktop, where there are many ad slots, to mobile, where there are far fewer and where people are less likely to click on them. As such, it’s inevitable the total number of clicks will struggle to grow even as overall traffic does, while the price per click comes down as Google expands into additional geographic markets with lower ad spending. The other wrinkle with the shift to mobile is Google has to pay out a higher portion of its ad revenues (as traffic acquisition costs) to mobile device makers like Apple and Samsung – Google Sites TAC in Q4 was up 48% year on year, even though revenue only went up by 20%, suggesting Google is having to pay out at a higher rate as more ad impressions come from mobile.

In its own business, YouTube has been a bright spot, as traffic on YouTube continues to grow rapidly and with it clicks (whether measured as actual clicks or merely people sitting through video ads). YouTube was an obsession for analysts on the Q4 earnings call because it’s the driver of much of the growth at Google. That’s clearly a good thing, but there’s a question about whether it can sustain that growth over the long term as other online video services continue to gain steam. The underlying model is still fantastic for Google – all it pays for is hosting expenses, while its users contribute all the content for free or merely a cut of the ad revenue. Lastly, there’s programmatic advertising, which isn’t necessarily a new revenue category at all but a way for Google to scoop up a bigger slice of the advertising value chain and potentially at higher prices thanks to better targeted ads. Google has repeatedly called out the growth in programmatic as another major growth driver, including in Q4.

Where Growth Comes from Next

So let’s return to the question of what all this says about where Alphabet’s growth comes from in the future. Other Bets will continue to grow, especially as businesses like Verily start to drive higher revenue from various partnerships, but that’s still a tiny contributor to overall growth and will continue to be so. Google Other revenue should continue to see a big boost from hardware sales in the next few months and, assuming we see a Pixel 2 and potentially additional hardware from Google later this year, this should become a useful revenue driver over time, boosting overall revenue growth for Alphabet. Play store revenue and enterprise cloud revenue will also continue to drive growth, with those two areas likely roughly matching hardware in terms of new dollars each year. Then there’s the Google ads business, where almost all the growth will continue to come from Google’s own sites and that growth, in turn, largely driven by YouTube and programmatics, while growth in mobile search merely offsets desktop declines rather than necessarily driving net growth.

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Jan Dawson

Jan Dawson is Founder and Chief Analyst at Jackdaw Research, a technology research and consulting firm focused on consumer technology. During his sixteen years as a technology analyst, Jan has covered everything from DSL to LTE, and from policy and regulation to smartphones and tablets. As such, he brings a unique perspective to the consumer technology space, pulling together insights on communications and content services, device hardware and software, and online services to provide big-picture market analysis and strategic advice to his clients. Jan has worked with many of the world’s largest operators, device and infrastructure vendors, online service providers and others to shape their strategies and help them understand the market. Prior to founding Jackdaw, Jan worked at Ovum for a number of years, most recently as Chief Telecoms Analyst, responsible for Ovum’s telecoms research agenda globally.

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