Alphabet Opens Its Books for the First Time: Where Does Google's Successor Start From?

This company still has a lot to show us

Early this morning, Google's parent company Alphabet released its first financial statements since it was created. On August 11, Google co-founder Larry Page announced in a surprise open letter that Google would become Alphabet, a collection of subsidiaries in which Google, home to all of the company's internet services, is just one member.

In this first report, Alphabet does not yet break out revenue by business. What we get is the picture for Alphabet as a whole (through September 30):

• From July to September, Alphabet's total revenue was US$18.675 billion, up 13% on the same period last year; profit was US$3.979 billion.
• Advertising made up 89.9% of total revenue.
• Five products each draw more than 1 billion users a month.
• The company holds US$60 billion in liquid funds.
• It employs 59,976 people.

Measured by how well prepared it is to explore the future, Alphabet starts from a very high point.

Market capitalization: the five major US tech companies, with Walmart and Alibaba for reference

Alphabet's chief financial officer, Ruth Porat, also announced a US$5 billion share buyback. It is one of a series of gestures toward Wall Street from a company that once kept its distance: Google, sorry, Alphabet.

Within hours of the release, Google's share price had risen more than 11%, adding US$45 billion to its market value.

Alphabet's Business: The Biggest Earner Is Still Google's Much-Questioned Advertising

Google's revenue has grown by more than 10% every quarter. For more than a decade, its search-plus-advertising model has met no competitor. It is the most profitable business model in the history of the internet, and also the least laborious.

Google's revenue growth, second quarter, 2008-2015

This remarkable curve comes mainly from two kinds of ads:

• Ads on Google's search pages;
• Google ads placed on tens of thousands of partner websites.

Google collects data through its own free services (search, email, YouTube and so on) and through its partner sites. It knows what each user likes and which ads will work on them.

For years, no company has come close to Google in the number of users its internet services reach. Google's biggest problem has simply been deciding where to spend its money. It has put a large share of its revenue into widening its lead, and plainly no search engine can now catch it.

But this easy money does not carry over to mobile phones.

First, few people use a search box on their phones. Google says users search it 50 billion times a month on mobile. That sounds impressive, but a rough calculation shows that half of mobile users barely use a search engine on their phones at all.

Smartphone apps have weakened search. For most everyday needs (the weather, a place, a restaurant, the news), an endless stream of apps offers to sort things out for you. Every Android phone comes with Google Search built in, yet information that once meant opening a search engine and typing a keyword now comes from lifestyle and utility apps.

The other major source of Google's ad revenue, partner websites, is in trouble too. A phone screen is too small to display web ads well. And where we once followed links from one web page to the next, content now lives inside apps. People have learned to look for things in apps: to buy something, they open a shopping app; to watch video, they open YouTube or Youku Tudou; to find news, they might open Toutiao, Weibo, Twitter, Facebook or Moments.

These apps, which take up most of users' time, all sell their own ads. Only YouTube belongs to Google.

Global phone shipments are growing 13% a quarter, and phones have replaced computers as the way people get online anytime, anywhere. Meanwhile Google's share of the mobile ad market keeps falling, from 52.6% to 46.8% in three years. Facebook, a social network, has leapt from 5.4% to 21.7%.

Google's desktop ad business is still growing, but as the PC market saturates it is nearing its ceiling (more here).

Beyond Search, Google Has Plenty of Ad Revenue Left to Tap

Sooner or later, Google has to work out how to sell ads on phones. But finding its next source of growth is not actually hard.

Years of ad revenue have let Google's founders try all kinds of novel ideas, and have also produced at least five internet products with around 1 billion users each. So far:

• Google Search: 5.724 billion searches a day
• Gmail: 900 million monthly users
• YouTube: 1.3 billion monthly users
• Google Maps: more than 1 billion monthly users
• Android: 1.4 billion monthly users, not counting Android users in China

YouTube is an obvious source of revenue, because it suits video ads. On the earnings call after this report, YouTube was named as one of the main drivers of mobile ad growth. Beyond ads, YouTube has also launched a paid membership and is making money through online stars.

Another source driving Google's mobile revenue is advertising in the Google Play app store. In China today, the rankings in Android app stores are set almost entirely by how much developers spend on ads. Store ads inevitably spoil the user experience, though; Apple, for one, offers no such service at all. Even if Google pushes Play hard, it will not let ads take over the store the way Chinese vendors have.

The biggest opportunity, and one Google has not tapped at all, is feed advertising.

Mobile ads today are no longer about banners. They are mostly ads slipped into feeds, whether Facebook's News Feed, Twitter's timeline, or the stream of stories Toutiao pulls together.

Google's failed social network, Google+, was once a chance at this kind of advertising. Google+ failed, but losing to Facebook in social networking does not mean Google cannot build a decent reading app.

Google started building news readers very early:

• After the September 11 attacks in 2001, an engineer launched Google News, a news aggregation search service, to gather news in one place;
• With RSS at its height, Google released the much-loved Google Reader in 2006;
• As the smartphone era arrived, Google Currents launched in December 2011;
• After Android Market became the Play Store, Google introduced a magazine feature similar to Apple's Newsstand, promoting traditional media's digital editions;
• Currents was later merged with the magazine feature to become Google Play Newsstand.

Of these five news products, most have been shut down, which shows Google had no real plan. Yet Google has a natural advantage in news: every day its search crawlers pull content from every news site on earth and drop it into the search box. The same content could just as well be dropped into a container like Toutiao.

In fact, apart from the final step of presentation, Toutiao does essentially what Google does, only more simply. As for the "intelligent recommendation algorithms" that Toutiao and other reading-app teams promote, hardly any company could do them better than Google.

And Google still has Android. Android runs on 82.8% of smartphones, and Google is not shy about wielding Android as a stick to force manufacturers to install its apps.

Apple is already doing this. Outside China, every iPhone upgraded to iOS 9 comes with Apple News preinstalled, whether users like it or not. Apple reorganizes and combines news sources, recommends topics and articles based on each user's reading habits, and shares ad revenue with the publishers.

Google may have had it too easy until now and ignored smaller ad opportunities. As the desktop search market saturates, it will have no choice but to pursue them.

With Android and the detailed user data its internet services collect behind it, Alphabet, if it wants to, has plenty of revenue left to squeeze.

Beyond Google, What Else Does Alphabet Have?

Google provides internet services and makes the money. It supports Alphabet's entire workforce of 60,000 and seven other companies that are not in internet services.

After the restructuring, each independent business at Alphabet became a separate company with its own CEO. Larry Page is now Alphabet's CEO, Sergey Brin its president, and Eric Schmidt executive chairman of the board.

This structure shields Google from its other "side-project" subsidiaries, so its financial results look better, which in turn lifts the valuation of Alphabet as a whole.

The subsidiaries will get the chance to act like startups, using smaller teams and Alphabet's money to shake up their own new markets. And because their businesses are separate, they can raise money and go public on their own, which should attract more talent.

But even though the founders say these projects will one day serve more than 1 billion people, businesses such as life sciences and life extension will not bring products to market any time soon, let alone earn money for Alphabet.

Smart Home Hardware: Nest

The smart home company Nest was founded in 2010 and bought by Google in 2014. Its CEO is Tony Fadell, a former Apple executive.

According to figures from before the 2014 acquisition, about 1 million households had bought a Nest thermostat. The cheapest model sells for US$199. Nest also makes smoke alarms, Dropcam cameras and other products.

Around Nest, Google has built a platform that third-party devices can access and connect to. Light bulbs, scales, routers, televisions, refrigerators, air purifiers and more from a range of makers now connect to this smart home platform with Nest at its center. On the software side, Google launched Brillo OS, an operating system for the Internet of Things, this fall.

The smart home market is expected to reach US$58.68 billion by 2020. Nest is a pioneer in the field and has Google's software and data behind it. Selling hardware will not bring explosive, exponential growth, but as smart homes spread, the well-reviewed Nest should at least have no trouble growing its sales.

Venture Investing: Google Ventures and Google Capital

Google Ventures is Google's venture fund for early-stage startups. It was founded in 2009 and is run by Bill Maris.

So far it has invested in 300 startups, spending more than US$2 billion in total, and has an annual investment budget of US$300 million.

Google Ventures has taken part in early funding rounds for many star startups, including Uber, Slack and Medium. According to a CB Insights report, it was the fourth most active fund last year. Six of the companies it backed have gone public, and 14 are valued at more than US$1 billion each, the so-called unicorns.

Over the next three to five years, these unicorns will be acquired or go public. Google Ventures owns only small stakes in them, but because it invested so early, it can expect handsome profits.

The other fund, Google Capital, was founded in 2013 and invests in mature companies. It has a 15-person investment team, whose three leaders report directly to Google senior vice president David Drummond.

Google Capital invests in startups in a phase of rapid growth. It has backed 24 companies so far, across a fairly wide range of industries: education, software, healthcare and finance. All of them have proven business models, can expand quickly and promise visible returns.

Health Care and Life Sciences: Life Sciences and Calico

Life Sciences began as a Google X lab project. It is led by Andy Conrad, who has spent more than 20 years in medical research.

Its main projects include a smart contact lens that tracks indicators of diabetes; the Liftware Spoon, a smart spoon for people with Parkinson's disease; the Baseline Study, which collects genetic and molecular information from people to map what a healthy human body looks like; and health-tracking wristbands.

A contact lens that can detect blood glucose

Development is moving faster than expected. The smart contact lens, developed with the Swiss drug giant Novartis, is expected to begin testing at major clinics next year.

Calico, by contrast, focuses on serious life-threatening illnesses and mental illness. Its team is a star lineup: the CEO is Arthur Levinson, Apple's current chairman; the CTO is Hal Barron, formerly chief medical officer at the drugmaker Roche; and the chief science officer is David Botstein, a genetics professor at Princeton University.

On the product side, Calico teamed up with the drugmaker AbbVie in February to develop treatments for diseases of old age. Under the deal, Calico will handle drug research and trials, while AbbVie will help with and handle product development and launch.

Most recently, Calico partnered with Ancestry. It will apply analytical tools and algorithms to Ancestry's huge genealogical and genetic database to study the family trees of long-lived people and the biological information in their genes. It will then build models from the results and turn them into products that analyze and predict individual lifespans, and gradually develop drugs to slow or stop aging.

Infrastructure: Google Fiber

Google Fiber was founded in 2010 to build high-speed internet infrastructure. In 2012 it began offering homes fiber service at 1,000 Mbps.

Google Fiber now serves residents in nine US cities. For US$70-120, users get internet service 100 times faster than conventional broadband.

The project is still expanding.

The Distant Future: Google X Lab

Some of the projects above came out of the Google X lab, which makes it look like Alphabet's research institute, preparing the technology of a decade from now.

The project most likely to leave the lab next is the self-driving car. Self-driving cars will not be on the road until 2020 at the earliest, and commercial use is further off still. But Google has hired John Krafcik, former president of the car-pricing website TrueCar, as the project's CEO, so it would be no surprise if Alphabet one day announced it would build cars itself.

Most of the ideas born here are still concepts, long-term research for the future: Project Loon, the balloon program to bring internet access to everyone; Project Wing, the delivery drone; and more...

Without a doubt, Alphabet still has a lot to show us.