Can Google Shake Off Its Path Dependence and Become More Than an Ad Company? | Top 15 Annual Report

The advertising ceiling is near. This is the moment Google has no choice but to change.

Google's biggest news in 2015 was, without question, that it stopped being called Google.

On August 11, 2015, Google co-founder Larry Page announced that Google would become Alphabet, with Google as one of its subsidiaries.

This sudden restructuring was something founders Larry Page and Sergey Brin had been weighing for a long time. Alphabet split the various businesses into separate companies. The smart-home company Nest and Google X, the lab that produced Google Glass, are now independent firms, and their CEOs hold complete independence and autonomy.

Alongside the Google everyone knows (search, Android, YouTube, and other internet services) sit the longevity-drug research company Calico, the investment firms Google Ventures (since renamed GV) and Google Capital, the network-services company Access and Energy, and the medical-technology company Life Sciences (since renamed Verily).

But apart from the name, Alphabet has changed little from the old Google: the two co-founders and former CEO Eric Schmidt still hold the reins, and the quarterly financial statements that break out subsidiary revenue won't appear until January 2016.

At least for now, Alphabet is still an advertising company — and its growth is nearing a ceiling

However many subsidiaries sit beside Google, advertising revenue remains the main engine that keeps Alphabet running. Over the past four quarters, advertising brought Alphabet $64.462 billion, close to 90% of total revenue.

For the past two years, Google's advertising revenue has held around 90% of total revenue — a share that has barely moved since the company found a steady source of income.

This past year, Google's advertising revenue still grew at double digits. By the numbers, the business looks strong.

But as internet users shift from the desktop to mobile, the damage to Google's search advertising is starting to show. The clearest sign: the cost-per-click (CPC) Google charges advertisers has fallen for three straight years. In the chart below, the CPC growth rate for each of the past three years is negative.

Google's cost-per-click has fallen steadily

CPC is a key measure of how appealing Google's ads are. Its decline means advertisers are shifting budgets to other channels, and Google has had to cut prices to keep advertising revenue growing.

The blame for eroding Google's grip on advertising falls largely on social companies, led by Facebook.

Facebook also draws 90% of its revenue from advertising. Its native trove of social data on users, together with its fast move onto mobile, lifted its share of global digital advertising revenue from 8% last year to 9.6%. In display advertising and mobile advertising alike, Facebook's share is climbing and Google's is falling.

Reaching a website through a search engine was once the first thing people did after turning on a computer. On the phone, that habit is gone. One app after another has replaced the search engine as the main point of entry. As attention moves from the search box to apps, the ad slots advertisers aim for move with it. Among the top 10 apps in the U.S. App Store, only YouTube belongs to Google, while Facebook owns four (Facebook, the Messenger chat app, and two Instagram apps).

Not until this October did Google's search volume from phones finally pass that from computers.

At the same time, as the internet population Google can reach worldwide tops out, the total volume of Google's advertising revenue is nearing its own ceiling.

Several market-research firms believe this trend will hold over the next few years, with Google ceding advertising share to social apps such as Facebook, Instagram, and Twitter.

Even YouTube, Google's advertising star on mobile, has an uncertain future.

YouTube video revenue growth is set to fall sharply after 2016

Desktop video advertising is near saturation, while on mobile YouTube faces challenges from Instagram, Twitter, and others. The in-feed video ads these apps offer make for a far better experience than YouTube's existing pre-roll format, and YouTube's video advertising revenue will reach an inflection point in 2016 as well.

Google's restructuring, too, is tied to advertising growth nearing a ceiling

When Google went public in 2004, Larry Page and Sergey Brin told investors, with characteristic willfulness, that Google would not adjust how it ran the business to suit how investors reacted to each quarter's earnings, and that the company would spend only on imaginative, long-term projects — even though such projects often could not offer a clear return forecast at the outset.

The breakneck growth of advertising was the one reason investors put up with Google for years. For more than a decade, Google's search-plus-advertising model met no real competitor — the most profitable, least labor-intensive business model in internet history.

But as the easy-money advertising model nears its end, Google has begun a series of adjustments. This March, Google hired Ruth Porat, a longtime Morgan Stanley executive, as its chief financial officer. Porat has done much to lift Google's margins: on the small side, cutting hiring and tightening limits on staff travel, event attendance, and other spending that brings in no direct revenue; on the large side, buying back shares to please investors.

Restructuring into Alphabet is the ultimate fix. On one hand, the new company will eventually open its books further, giving investors a clearer view of how each business runs. On the other hand, the condition for each subsidiary CEO's high degree of independence and autonomy is that these subsidiaries must one day leave Alphabet's wing, weather the commercial world on their own, and prove their worth.

"Scarcity of resources is the catalyst for creativity" — that is how How Google Works, co-authored by Schmidt and Jonathan Rosenberg, describes forward-looking projects, because "over-investment breeds a stubborn bias, where people see only the upside in projects that have received heavy resources and can no longer make clear-headed decisions."

As part of the restructuring, Alphabet also turned formerly free Google resources into paid services for its subsidiaries — marketing, recruiting, and even the most basic servers now carry a price.

Standing on their own feet, and even growing into the next giant, is what Alphabet hopes for, and demands, from these subsidiaries.

This structure also reports the finances of Google and the other subsidiaries separately, so investors can see exactly where the money Google earns goes — giving them more to judge the prospects of the forward-looking projects and the value of Alphabet as a whole.

Google has many chances beyond advertising, and has yet to start mining any of them

Future technologies like self-driving cars and longevity drugs need time before they can become reliable revenue. Until then, what Alphabet can still mine is internet services.

Beyond search, Google has a string of internet products with more than a billion users each: Android, the Chrome browser, the Play Store, the YouTube video site, Gmail, and more.

But search advertising came so easily that Google has never seriously mined the potential of these services — news reading, for one.

Google's search crawlers pull content from every news site on earth each day and drop it into the search box. The same content could be dropped into a container much like Toutiao.

In fact, what Toutiao does is basically the same as Google, only simpler, apart from the final step of presentation. As for the AI recommendation algorithm Toutiao promotes, it plainly cannot match Google's technical strength.

Yet within a few years Toutiao has grown into an internet service with more than 1 billion yuan in annual advertising revenue. Google, meanwhile, has built five different news products in succession — Google News, Google Currents, Newsstand, and others — most of which it has already shut down. Google clearly has no plan here.

Productivity software is another chance Google has missed. Google Apps, launched in 2010, was once seen as an online productivity tool capable of unseating Microsoft Office — which earns Microsoft billions of dollars in profit every quarter.

Microsoft was slow to react: Office 365, the online suite launched in 2011, was a disaster, and only in 2013 did it become usable; the phone and tablet versions did not arrive until 2014.

But this year the picture has changed completely. According to an August report from the cloud-security firm Bitglass, 25.2% of enterprises now use Office 365 — already past Google's 22.8% — whereas last year Microsoft held only 7.7%.

Over those four years, Google Apps, despite its first-mover advantage, ran almost no large-scale marketing and was unwilling to meet customers' demand for local document-editing tools. By contrast, Amazon's AWS cloud service, which also competes with Microsoft for enterprise customers, has spared no effort in the market: it has recruited a large enterprise sales force and holds the AWS re:Invent conference, attended by thousands, every year. Today AWS is the undisputed leader in cloud computing.

YouTube Red, the paid video service launched this year, is Google's latest attempt beyond advertising.

A little like Bilibili in China, YouTube is an irreplaceable video service worldwide. It gathers original video programming of every length, naturally suited to phone viewing.

But sitting through 15 to 30 seconds of ads for one minute of entertainment is not acceptable. At $9.99 a month, YouTube Red is Google's exploration of a new business model.

YouTube Red carries exclusive original shows from online stars — for example, the Swedish gamer PewDiePie will stream a reality show called 《Scare PewDiePie》 on it — and Google will give creators 55% of subscription revenue.

But once advertising is out of the picture, the monthly-fee YouTube Red will ultimately face Netflix and Amazon, which buy vast amounts of video programming and produce their own films and television.

Google has decided to buy films and TV content from Hollywood and join the contest, though that will be yet another new thing. Next year, Netflix alone plans to make 31 TV series, 10 films, 30 children's shows, 12 documentaries, and 12 talk shows.

This time, can Google — which botched the music and video stores on Android — learn the new game?

Returning to the Chinese market would also require Alphabet to change

China is the only internet market in the world Google has yet to enter. The restructuring has set the stage for Google's services to return.

A month ago, co-founder Sergey Brin revealed that subsidiaries could decide for themselves whether to enter China. Several Google executives had floated the idea of bringing internet services back to the Chinese market; until now, Google had kept only an advertising business in China, helping Chinese companies advertise in global markets.

China's complexity goes beyond policy. Google's rivals have grown from a lone Baidu search engine, Amap, or QQ Mail into a full set of systems and services: handset makers with hardware and OS advantages, and Baidu, Tencent, and Alibaba, each with a complete service stack.

In five years, Baidu's market value has grown from a little over $10 billion to more than $70 billion today, while Tencent's has already topped $180 billion.

Google's core products — search, YouTube, Maps, Gmail, and others — already have full substitutes in China. The Play Store is the product best suited to entering the country. As of June 2015, among the 670 million people in China with internet access, 88.9% went online by phone.

But the phones Chinese people use have also changed over those five years, from international brands to Apple and homegrown Android brands. Apple has already broken with Google, and domestic Android makers — from the biggest, Huawei and Xiaomi, down to Meizu, OPPO, and even Smartisan — have each begun earning money through their own app stores to subsidize price competition. How would the Play Store find allies? The playbook it is used to running worldwide simply won't work here.

Larry Page wrote in his preface to How Google Works: "In technology, change usually comes suddenly, not step by step." Now the change has reached Google itself.

2015 may be the year of greatest change since Google's founding. The results of this year's many adjustments will show over the years ahead.

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Cover image from washingtonpost