Cloudy With A Chance Of Google
The cloud is a relatively new business model that allows companies to not have to manage physical servers themselves or run software applications on their own machines. Instead, companies can now save time and money by ditching physical servers and switching to Google, Microsoft and Amazon Cloud.
Not only is this new industry growing incredibly quickly, but it also holds the potential to achieve very high profit margins. High margins can be achieved because once the systems are put in place, cloud providers, like Google, can charge much more for taking on a company's incremental capacity than they have to spend on servicing it themselves. This sort of business model is said to have high operating leverage.
However, what I think is interesting about the Google Cloud in particular is that it still loses money!
So not only is the cloud business potentially unaccounted for in Google’s overall valuation, it may actually be counted against them by detracting from overall company earnings.
For example, in the last 12 months Google Cloud actually lost $3 billion… but at the same time it grew its top line by 46% !
It would be fair to say that at the moment, Google is more focused on growing their cloud businesses revenue than they’re worried about making it profitable.
I think that by looking at Amazon’s Cloud business today, we may be able to get a sense of what Google’s Cloud business could look like in the future.
In 2019, Amazon Cloud posted an operating margin of 26%. The operating margin has been around 30% ever since. If we apply those 26% margins to Google's cloud business today, we would go from it losing $3 billion dollars to making about $5 billion, an $8 billion swing!
If the business continues to grow for another 2 years at just 30% and could achieve those 30% margins like Amazon does, instead of detracting $3 billion, Google Cloud would add about $10 billion.
We may not be too far off from a point where Google Cloud becomes a significant part of overall company earnings and value, making Google more than just a search business.
Note - if we forget about the cloud business, at todays valuation we’re only paying about 14x’s EBIT for Googles legacy search business. That means that the market as a whole is trading at a more demanding valuation than Google is…and I definitely think Google is a much more quality business than the average company in the S&P.