Communications of the ACM

Technology strategy and management

Is Google's Alphabet a Good Bet?

By Michael A. Cusumano
Communications of the ACM, January 2017, Vol. 60 No. 1, Pages 22-25
10.1145/3018990
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Google Inc., founded in 1997 by Larry Page and Sergey Brin, went public in 2004 to a great deal of fanfare (see "Google: What It Is and What It is Not," Communications, February 2005). It reached another milestone in October 2015 when it reorganized as Alphabet Inc. The company was the second most valuable firm in the world as of November 2016, worth around $528 billion, not far behind Apple ($589 billion) and ahead of Microsoft ($468 billion). The Google Internet business still centers on a unique search technology based on page-rank algorithms and generates enormous revenues from targeted advertisements and sponsored ads. Scale economies and network effects (that is, the more users of Google search, the more accurate the searches and ads become) also have contributed to Google's success. But is Google's transformation into Alphabet Inc. a good bet—for Google investors and users, and society more broadly? That simple question raises big issues, such as how much should we expect large corporations to invest in research that might benefit society but not their bottom lines, and how might large corporations better use the money they do invest in research and new ventures?

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Google has always experimented with new product and service ideas as well as acquisitions, some more successful than others.

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It was never the case that Google's founders saw their future as limited to search. Google has always experimented with new product and service ideas as well as acquisitions, some more successful than others. Google+, introduced in 2011 to compete with Facebook, has struggled. But Gmail, introduced between 2004 and 2007, Google Maps, introduced in 2005, and YouTube, acquired in 2006 (for $1.65 billion), have greatly expanded Google's Internet platform. In 2005, Google really hit a homerun when it bought a small company called Android for an estimated $50 million.⁹ In 2007, it used the technology to launch a new mobile operating system to compete with Apple's iOS. Google Android now leads the industry with over 80% market share.^a Largely on the strength of mobile searches from Android phones and tablets, Alphabet's revenues in 2015 were nearly $75 billion, with operating profits of over $19.3 billion—a profit rate of 26%, compared to 30% for Apple and 19% for Microsoft and IBM.

Let's look more closely at how and why Google reorganized. The new structure created a holding company that breaks out the core and non-core operations (including research) into separate subsidiaries (internal divisions). This change clarifies which operations make money and which do not. The largest subsidiary retains the name Google. Now headed by Sundar Pichai, this division controls the related Internet businesses such as Search, Gmail, Android, Chrome, YouTube, Maps, Google Play, and Ads. Alphabet lumps the other subsidiaries into a single category called "Other Bets." These consist of Nest, Google Access (formerly Google Fiber), Calico, Verily, Google Ventures, Google Capital, Jigsaw, Sidewalk Labs, and the Google X research labs.

Some Other Bets, such as Nest and Fiber, are real, albeit modest, businesses. Like Android, Google Maps, and YouTube, they are not all the results of in-house research projects. Google bought Nest Labs (https://nest.com) in 2014 for $3.2 billion—now seen as a high price given current revenues estimated to be a few hundred million dollars per year.⁶ Nest sells smart thermostats and smoke detectors, as well as indoor and outdoor webcams (from another acquisition). It is developing other devices for the "smart home" and the Internet of Things that may someday sell in volume. Google Fiber, started in 2010 as a research project, brings very-high broadband speeds to millions of subscribers. Now called Access, the company sells a 1Gbps connection for $70 a month, the fastest in the industry, but still has relatively few subscribers due to limited availability. It has also incurred enormous capital expenses—$6 billion to lay cables in just six cities. One estimate is that it will take 40 years to recoup the investment simply on the first six cities, yet Access has plans for 16 more cities. Not surprisingly, Alphabet CEO Larry Page recently ordered that employee numbers be cut in half and other expenses reduced.⁷

Other Bets subsidiaries are all early-stage ventures or research organizations, mostly intended to benefit society and not necessarily become great new businesses in the short term. So investors should not expect them to generate profits now—but what about in the future? After all, Alphabet is a for-profit company, supposedly focused on organizing the world's information and then providing various Internet-based services. Some new ventures don't fit this vision at all. For example, Google established Calico (https://www.calico-labs.com/) in 2013 to tackle aging and related diseases, with the primary goal of extending life. It has not announced any drugs or therapies, but has hired prominent scientists with backgrounds in cellular biology, genetics, synthetic biology, opto-genetics (using light to manipulate cells in living tissue), and cancer research.¹ By contrast, Verily (https://www.verily.com/) dates back to a Google X project launched in 2012 to put computing inside contact lenses. This effort led to the Verily spinoff in 2015. With about 400 employees in 2016, Verily has continued to work on contact lenses that can do tasks such as measure glucose levels for diabetics. Other Verily projects include a health-tracking wristband, surgical robots, and health-related "baseline" databases. The goal of transforming healthcare with technology remains core to the company and does fit, more or less, with Google's original vision, though many key researchers have recently left due to vague objectives and leadership conflicts.¹⁰

Larry Page made it clear years ago that he intended to use Google's profits to invest in "moonshots"—new product and service experiments that promised revolutionary innovations and "10x" performance break-throughs.⁸ These goals motivated him to create Google X in 2010 as a research organization that has since worked on everything from self-driving cars and wearable computers to machine translation, artificial intelligence, and quantum computing (see https://research.google.com/). The labs sometimes launch initiatives that help the core businesses, such as machine translation or use of AI in search. But the stated mission is really to tackle bold new projects that potentially could change the lives of billions of people. Although many proposals seem to border on science fiction, to be approved, they must also put together technologies that already exist or nearly exist.⁵ The current set of initiatives include the self-driving car, more development on Google Glass (the head-mounted display and wearable computer that, in beta release, had trouble generating third-party applications and user adoption), Loon (using balloons to bring Internet access to remote areas), and Wing (drones for package delivery, similar to the Amazon initiative).

In 2012, Google also restructured its shareholding system into dual share classes in order to allow the company founders to control voting rights.¹¹ So, in fact, Larry Page and other company leaders do not have to worry too much about shareholder pressures for short-term profits. Nonetheless, analysts and investors have criticized him for spending so much money on projects that do not help Google's core businesses.⁴ The Alphabet reorganization does nothing to address these criticisms except to clarify where money is going—but only in the aggregate. For example, Alphabet's 2015 Form 10-K annual report now breaks out the core Google operations from Other Bets (see the accompanying table).^b We can see that the Other Bets subsidiaries have grown revenues from $12 million in 2013 to $448 million in 2015. If we read the fine print in the annual report, we also learn that the revenue increase comes largely from the sale of Nest devices. At the same time, Other Bets' operating losses grew from $527 million in 2013 to a staggering $3.6 billion in 2015.

Meanwhile, Alphabet increased overall R&D expenses in 2015 (these include Other Bets as well as Google) to over $12 billion. This sum represented 16.3% of total revenues, up from the 12.8% of revenues that Google averaged from 2006 to 2013. Without the nearly $3.6 billion loss from Other Bets, in 2015 Alphabet would have had an operating profit of about 36% of sales, rather than 26%. Maybe this money is being well spent-but maybe not. The latest Alphabet R&D expenditures are especially high compared to Apple, which, in 2015, spent only 3% of its revenues on R&D. Amazon, Microsoft, Cisco, and Oracle all invested between 12% and 14%, much closer to Alphabet. IBM spent 6%. Among other large technology firms, the leaders in R&D spending in 2015 were Intel (22%), Facebook (27%), and ARM (29%), though most of these expenditures appear directed at incremental product development rather than moonshot-type research.

Perhaps the biggest implication from the Alphabet reorganization is what it says about the company's commitment to experimentation. There was a time when major corporations like AT&T (with Bell Labs) and Xerox (with Xerox PARC) made bold investments that generated whole new industries like semiconductors, personal computers, and networking technologies. These innovations were only tangentially related to their core businesses and mostly benefitted other firms (Apple, Microsoft, Intel, and other chip manufacturers), as well as society. As a result, most big corporations over the past two decades have scaled back or even disbanded basic research that did not tie in to product divisions and the large, centralized research organizations needed to sustain these efforts.² Instead, we find research universities taking the lead in searching for scientific breakthroughs and some new applications intended to benefit society, though often the universities work in partnerships with corporations, government labs and programs, and some venture funds.

So is Google and now Alphabet a good bet for investors given its commitment to "moonshot" research, related and unrelated to its core businesses? Most projects have not produced much revenue so far, and they are a growing drag on profits.³ Maybe this would not be an issue if a corporation has enough resources (people and money) to do both long-term research and to keep improving its main products and services. However, we have not seen many breakthroughs from Google X in search technology, operating system design, application development environments, or related Internet services.

It is worth noting that other technology billionaires, such as Microsoft founders Bill Gates and Paul Allen, as well as Amazon founder Jeff Bezos, also have invested vast sums in bold initiatives unrelated to the businesses of their original companies. But they have done so mostly in separate ventures and mostly with personal funds, including donations to foundations, and other investor money. Elon Musk, with Tesla, SpaceX, and Solar City, is also a big personal investor in moonshot-type ventures, but he is also using funds from investors who should know what they are doing.

Here the transparency we see in the Alphabet restructuring is an improvement. As long as Alphabet-Google has the money, and investors know what they are investing in, it is important for society that someone takes a chance on risky new ventures. We will never reach the moon again or make equivalent leaps forward in science and technology if no one tries. AT&T Bell Labs is not what it once was and Xerox PARC no longer exists. IBM, Microsoft, General Electric, and a few other companies continue to do some basic research, but they are all under pressure to assist their product divisions and generate new billion-dollar businesses.

Alphabet's Other Bets may yet produce some great new businesses for the company as well as contribute to the betterment of humankind. In the meantime, though, shareholders need to understand that the money is coming out of their pockets, and so it would be useful for Alphabet to be even more transparent with details on the individual bets. In addition, Larry Page and other company leaders should acknowledge more openly that these expenditures may also be at the expense of innovations that could more directly benefit the billions of current Google users as well as ensure that the company remains healthy long into the future.

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