Introduction

In this paper, I will discuss the antitrust risks that Alphabet (GOOG) is currently facing. In my view, Alphabet is the company facing the most significant antitrust risks among large technology companies, but these risks have been overshadowed for years by the controversies surrounding Facebook (FB), Apple (AAPL) and Amazon (AMZN). Tons of reports from reputable news agencies mention that the DOJ and a group of states are separately investigating Google’s dominance in multiple market segments. However, the sources of these reports are most often anonymous sources or Google’s direct competitors such as DuckDuckGo. It is therefore possible that these reports are partially incorrect. In this article, I will examine Google’s dominance in detail, discuss the market segments in which Google’s dominance could be weakened if competition lawsuits were brought, and answer the question that everyone is asking: Should investors be concerned about possible competition lawsuits?

Antitrust

U.S. federal and state authorities are ready to prosecute cartel cases “as early as this summer”, according to “people who know the case well”. However, the decision to actually file a complaint has yet to be made. The group of states is likely focusing on Google’s “online advertising activities”, according to Wall Street Journal sources familiar with the case, while the DOJ is probably taking a broader approach focused on Google’s dominance in online search, but their approach has probably become more focused on Google’s advertising tools over time, according to Wall Street Journal sources familiar with the case.

Attorney General William Barr has made the Google investigation a top priority, and Paxton says states are not slowing down their investigation

There are many reports from several reputable news agencies that give the impression that the authorities are really trying to get a foot in the door of Alphabet. I suppose this is due to Google’s domination of advertising space:

The company (Google) has the dominant tool at every link in the complex chain between publishers and online advertisers~The Wall Street Journal~

I will now talk about this supposed dominance spread across several market segments. The reader will come to understand that all these different segments are in fact nested within each other.

Search engine

The first market segment where regulators might think the alphabet is too dominant is in search. Google’s market share in the global search engine market is huge, but it has declined somewhat in recent years. In April 2020, Google’s market share was 92% according to the statistics counter. Yet Google’s dominance in the search engine market has allowed smaller competitors to become profitable. Bing and DuckDuckGo are both profitable companies.

(Source: Statcounter)

On the other hand, the wider research market is beginning to warm up. Amazon is not a search engine but offers search services on its website. Amazon’s strong presence in the e-commerce market has encouraged customers to use Amazon.com directly when searching for goods. As a result, Amazon has experienced high growth rates in search ad revenues. Previously, users would have started searching on Google, which is very lucrative for Alphabet shareholders, but now they search directly on Amazon. As Amazon’s dominance increases, it is estimated that Google will begin to lose search revenue to Amazon.

According to eMarketer, Google’s share of U.S. search revenues remains huge, with a record 73.1% in 2019. However, Amazon is expected to become a formidable second player in a few years.

“Amazon’s advertising business, for example, has attracted massive increases in advertising spending because advertisers can reach the public via interest-based signals – requests for products – and in a context where they are willing to buy

(Source: eMarketer)

“US federal and state authorities are asking detailed questions about how to limit Google’s power in the online search market in their antitrust investigations of the technology giant, according to rival DuckDuckGo Inc ~Bloomberg

According to Google’s competitor DuckDuckGo, the authorities want to offer consumers more search options on Android devices and the Chrome browser. This would certainly be a good thing for DuckDuckGo. In Google’s defence, changing your Chrome search engine from Google to DuckDuckGo can be done in seconds. But it’s plausible that Chrome users in the future won’t get Google as their default browser, but rather have to choose their own default browser.

I don’t think there will be major changes in the search engine market as a result of regulatory intervention, but it remains a possibility. I think the risks are low, because Google can argue that Amazon continues to increase its market share in the search sector and that its other direct competitors in search engines are profitable.

The digital advertising market

The second market segment where regulators may think that Alphabet has too dominant a position is the digital advertising market. For a reader to understand Alphabet’s dominant position in the digital advertising market, one must first understand this principle. The effectiveness of an advertisement can be improved by a better understanding of the users; more data leads to better understanding and therefore greater effectiveness. Alphabet has the largest ad exchange on the Internet, the DoubleClick Ad Exchange, which has nearly 50% market share. Ad exchanges are the intermediary between third-party websites and advertisers. The DoubleClick Ad Exchange is an essential part of DoubleClick. DoubleClick is known as an ad server, it is a platform that connects websites that want to sell ad space with the ad exchanges, this includes the DoubleClick Ad Exchange but also other ad exchanges. One thing is essential to understand here, according to the Wall Street Journal, “more than 90% of major publishers use Google’s ad server, DoubleClick for Publishers”. Why is this vital? According to the FT, ad servers can track the activity of websites that use the ad server. Thus, in theory, Google is able to obtain tons of navigation data on most high-traffic websites.

(Source: Datanyze)

Alphabet obviously owns Google’s properties: YouTube, Google Search, Google Maps, Google Images, Gmail and the list goes on. As I said earlier, more data translates into more effective ads and therefore higher margins, greater market share, and so on. It is plausible that Google could use the data obtained through DoubleClick services to increase the effectiveness of ads on Google properties.

“The main intermediary between advertisers and publishers is Google. They hold the bulk of the technical stack between advertisers and publishers” ~Damien Geradin, lawyer ~

One can seriously question whether it’s a fair market that Alphabet owns DoubleClick, while owning all of Google’s valuable properties. According to the Wall Street Journal, Elizabeth Warren “has proposed to cancel the Google-DoubleClick merger”.

Google’s Adwords platform, which is Google Search’s advertising platform, allows advertisers to purchase ad space from AdX, DoubleClick’s ad exchange. In this way, Google’s properties stimulate sales to AdX. According to the Wall Street Journal, Google now also allows competing exchanges to sell advertising space on Google Adsense.

This shows how all these different platforms are connected and how difficult it is to understand Google’s dominance in the digital advertising market.

Any regulator that digs into Google’s business model faces multiple challenges. First of all, they have to understand Google’s business very well, so that they can understand all the moving parts. Second, they have to find a way to demonstrate that dominance, because, frankly, Google’s business model is more complicated than we think.

“I hope we’ll realize it by early summer, and by realize, I mean time to decide.” ~Mr. Barr, in reference to the Google probe~

However, the most difficult question, in my view, for any regulator that goes after Google is how to combat this dominance. Splitting the companies into an entity separate from Google Properties and a DoubleClick entity may not entirely solve the problem, but it may be an improvement. One scenario I can imagine is that the separate companies simply buy each other’s data, but at least now, in theory, other large players could also get the data, although Google’s capital makes it difficult to outbid them. This creates a somewhat more level playing field.

In general, a split of Google and DoubleClick could be very difficult, according to lawyers who spoke to CNBC. The problem is that over time, Google and DoubleClick have become very connected, which makes it difficult to split them up.

“The courts are very concerned that by dismantling a company, they are harming consumers and making it worse for people who don’t have the skills to do it~Stephen Houck, Google consultant

The group of states has not ruled out the possibility of trying to split Google according to CNBC sources. The question that regulators and possibly judges must answer is whether a split does more harm than good or more good than harm.

In 2008, the Federal Trade Commission had to decide whether Google was allowed to take over Doubleclick. In the end, it gave its approval. According to the Wall Street Journal, a former FTC official said

“At the time, it seemed like the right decision, but things have changed a lot in the last 12 years.”

I think it’s quite likely that the regulators will try to split Alphabet and DoubleClick. I think this could significantly weaken the Alphabet moat in the digital advertising market.

Android

According to sources at Politico, another potential settlement would involve Google relinquishing control of the Android mobile operating system. This issue has been controversial for years. Android has a dominant market share in the mobile operating system market.

(Source: stat counter)

This is, in my view, the biggest risk for Alphabet shareholders, because Android is a very valuable operating system, and regulators could argue that Google should not own Android. Alphabet is using Android to impose its own Google, YouTube, Chrome and Gmail properties on Android customers, which does not bode well for the principle of a fair market and reinforces its dominance in multiple market segments. And it’s quite a rodeo to remove preinstalled applications. Remember that more data means more effective ads, and so Google is using Android’s dominance to acquire more data with its Google properties on users. The European Commission has in fact fined Alphabet €4.3 billion for using Android’s dominance to “strengthen the dominant position of Google’s search engine”.

“The Commission’s decision concludes that Google is dominant on the markets for general internet search services, licensable intelligent mobile operating systems and application stores for the Android mobile operating system~European Commission

“Google’s practice has therefore reduced the incentives for manufacturers to pre-install competing search and navigation applications, as well as the incentives for users to download such applications. This has reduced the ability of rivals to compete effectively with Google~European Commission

I think it’s very plausible that eventually Android will have to be separated from Alphabet, or that Android will no longer be allowed to be pre-installed with some of Google’s properties. They also have the largest AdMob ad exchange for third-party applications, which is very comparable to DoubleClick’s ad exchange, which also connects advertisers with ad space. I guess regulators might criticize the fact that Google owns AdMob, and the strategy used to develop AdMob. According to Reuters :

“The biggest choice for many application developers is between Google’s AdMob and DoubleClick. It’s not clear which one is growing faster because Google doesn’t provide this data.”

“Yet Google’s strategy is to win customers. Google gives developers about 70 cents out of every dollar it collects from ad buyers, compared to 50 to 60 cents from some of its competitors.”

Android is another piece of Google’s complicated puzzle, this section shows once again how the different properties of Google are really linked together.

(Source: statcounter)

Chrome

Google’s highly successful Chrome browser could also be involved in a possible agreement with regulators. According to statistics, Chrome has a huge 64% market share in the browser market. The browser’s success can be partly associated with its well-constructed base, but its success is not only due to the technical details. Google pre-installs Chrome on Android devices, and Chrome is practically advertised on Google search and other Google properties.

(Source: Techdows)

Google has used its dominance in other areas to impose Chrome on users. I consider it unlikely that Chrome will be separated from the company as a whole by a regulator, but I think it is likely that Chrome will undergo some minor changes. This could mean that Google will no longer use its other properties to gain Chrome users

(Source: stat counter)

TAC

Traffic Acquisition Costs, TACs, are an excellent way of determining whether Google is using its dominant position in certain market segments to reduce the costs of acquiring traffic to its services. These traffic acquisition costs include ‘partnerships and distribution agreements’. Partnerships can be websites, applications or YouTube channels, which use Google’s DoubleClick, AdMob or Adsense program, where the third party’s share of revenues is a traffic acquisition cost for Google. In distribution agreements, Google, for example, pays companies to include Google software in their phones.

Google can, in theory, use its dominant position in the ad market to reduce the TAC. For example, Google can take a larger share when it puts ads on third-party properties, the DoubleClick platform and AdMob we’ve talked about. There are many ways in which Google can use its dominance to reduce the TAC. But one thing is clear, the TAC costs relative to Google’s revenues have been decreasing over time. On the one hand, this includes all of Google’s assets, and therefore also Google Search and Gmail. Since Google owns Google Search and Gmail, and these two services have strong gaps, the TAC/revenue will be very low. What the trend shows is that Google has been able to increase its gross margins. I think Google Search is the determining factor. But there are a lot of factors at play, and it’s difficult to determine what has driven the TAC/revenue down.

(Source: Fourweekmba)

From 2018 to 2019, the TAC’s share of Google’s revenues increased from 19.65% to 18.26%. Once again, this shows that Google continues to increase its revenues while increasing its gross margins. An excellent business model. However, it also shows that Google could abuse its power for its shareholders. This is the question that regulators must answer.

A wonderful company

Alphabet is the conglomerate, one of whose subsidiaries is Google. Alphabet’s steady growth in revenues and EBITDA has been spectacular to say the least. The profitability of Google’s search business has been the solid foundation that has given Alphabet the capital to grow extensively.

Alphabet is very slowly diversifying its business away from Google Search and other Google properties. Each year, Google Search’s share of Alphabet’s total revenue has declined and I expect this trend to continue. Currently, Google is creating most of the value for Alphabet’s shareholders since Google’s operating income in the first quarter of 2020 was $9.270 billion and Alphabet’s operating income was $7.977 billion, which means that Alphabet’s new investments are currently costing the company money. Except that these are long-term investments and they include loss-making companies like SpaceX and Waymo, which are ready to change the world.

(Source: Visualized in Excel, IR Alphabet data)

Microsoft

Possession of Alphabet comes with regulatory risks. The showdown between regulators and Microsoft in the 1990s is a similar situation. Microsoft (MSFT) was the subject of an antitrust lawsuit with the DOJ. The DOJ was trying to argue that Microsoft was using its dominance of the operating system to develop Internet Explorer. They reached an agreement that Microsoft should, inter alia, accept other browsers on Windows. Without this lawsuit, in my opinion, Google could never have existed. Microsoft’s Bing would have been the Google of today. The irony is that Google may not respect the free market, which gave Google the opportunity to exist. This huge lawsuit in the 1990s against Microsoft tarnished Microsoft’s strong brand, and slowed Microsoft down in terms of innovation:

There is no doubt that the antitrust lawsuit was bad for Microsoft, and we would have been more focused on creating the phone’s operating system, so that instead of using Android today, you would be using Windows Mobile. The Doors of Billing

Nicholas Economides, a respected academic, also wrote an in-depth analysis of the Microsoft antitrust lawsuit while it was still ongoing. He wrote:

Microsoft’s biggest loss is the permanent antitrust watch that prevents it from making any significant acquisitions in telecommunications and internet in the US during the period of intense antitrust surveillance ~Nicholas Economides

The Microsoft example shows that antitrust lawsuits can harm a company’s ability to innovate, a risk that Alphabet’s shareholders must take into consideration.

Takeaway

We do not know what the consequences of a possible antitrust action against Alphabet will be, frankly it is always possible that an antitrust action may never be fulfilled. I think that any antitrust case can lead to a weakening of the dominant position in certain markets. For example, Google Chrome may lose market share, Google may have to exit the mobile operating system market, Google may have to divest itself of Doubleclick and/or Admob, and Google’s innovative power may be weakened if a hypothetical antitrust case takes ages and starts to fester. These are realistic examples of a weakening of Google’s dominance. These hypothetical scenarios will obviously affect Alphabet’s shareholders, but I suspect that they will be less significant than people might fear. 73% of Google’s advertising revenues in 2019 come from Google Search, only 17% from members of the Google network, which includes Admob and Doubleclick. I also suspect that Google Search’s margins are much higher than those of Google’s other advertising segments. I find it implausible that Google Search’s revenues would be significantly affected, and since they contribute the majority of the profits, I consider the impact on the bottom line to be minor.

In short, I think that investors should not be overly concerned about regulatory risks, but understand that Google may undergo some changes and that, as a result, Google’s moat may be weakened in some areas. Alphabet really is a great company, and it has rewarded its shareholders for decades, and I think they will continue to do so.

Did you like my article? I write a lot about the internet and under-covered European equities. Don’t forget to follow me to be notified every time I publish a new article. You can follow me by going back in time and clicking on the “Follow” button next to my profile

 

Disclosure: I am/we are long FB, AAPL. I wrote this article myself, and it expresses my own opinions. I receive no compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose actions are mentioned in this article.

Additional information: Some of the research in this article may not be entirely accurate, as many sources as possible have been used to prove its value, but inaccuracies can still occur. This article is intended as an analysis to inform investors about what hypothetical antitrust lawsuits could involve. This article is in no way intended to be defamatory. I recommend that investors do their own due diligence.

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2020-07-06