sefa ozel
In my latest article on Alphabet Inc. (NASDAQ:GOOG)(NASDAQ:GOOGL) (“Google”), which was published last week, I highlighted the company’s dominant position in the digital ads market and how its business is able to continue to grow at a double-digit rate despite the turbulent macroeconomic environment. At the same time, I’ve also noted that the only major thing that can disrupt Google’s growth is additional regulatory pressure from antitrust watchdogs from both sides of the Atlantic, who are actively trying to challenge its monopoly in the market.
While I continue to be bullish on the company in the short to a near term, as Google has all the chances to continue to aggressively grow despite the additional regulatory pressure, I still think that investors need to be aware of the long-term threats that additional regulations could pose to the business’s dominance in the digital ads field. Therefore, the goal of this article is to highlight the latest regulatory developments that have already negatively affected Google, explain how the regulatory environment could evolve in the following years and which parts of Google’s businesses are at risk of breaking up by the end of this decade.
Don’t Underestimate The Power Of The Department of Justice
In late 2020, the U.S. Department of Justice filed a complaint against Google in which it stated that the company is paying billions of dollars to other businesses in order for them to make Google the primary search engine. Here are the exact words that are used in the complaint:
For years, Google has entered into exclusionary agreements, including tying arrangements, and engaged in anticompetitive conduct to lock up distribution channels and block rivals. Google pays billions of dollars each year to distributors—including popular-device manufacturers such as Apple, LG, Motorola, and Samsung; major U.S. wireless carriers such as AT&T, T-Mobile, and Verizon; and browser developers such as Mozilla, Opera, and UCWeb— to secure default status for its general search engine and, in many cases, to specifically prohibit Google’s counterparties from dealing with Google’s competitors. Some of these agreements also require distributors to take a bundle of Google apps, including its search apps, and feature them on devices in prime positions where consumers are most likely to start their internet searches.
This complaint is important because it was filed by the general attorney at the end of the Trump administration tenure and it continues to be pursued under the current Biden administration, which signals that there’s a bipartisan interest in putting more pressure against the Big Tech and creating a more strict digital regulatory environment.
In its complaint, the Department of Justice has requested the court to recognize Google to be in violation of Section 2 of the Sherman Act and require the company to scale back its dominance in the digital search market. Even if the Department of Justice manages to score a win, then the potential fine is not going to be that big of a deal for Google, as corporations that violate the Sherman Act can be fined up to $100 million for each offense. Considering that at the end of June Google has $125 billion in cash reserves, any fine is going to be more than manageable for the company.
However, if the court forces the company to scale back its search business, then Google could be in serious trouble, as the search business is the single biggest source of revenue for the company, which generated $40.6 billion in revenues in Q2, accounting for nearly 60% of all revenues during the period. Any disruptions in that business in the future could strip the company from its advantages in the digital ads market and make it harder to compete with its peers or attract new advertisers.
The good news for Google is that the depositions began only last week, and currently there’s a possibility that only a summary judgment about some of the Department of Justice allegations would be made by the end of the year, while the court ruling along with a possible appeal later could take years. Therefore, as I’ve already earlier stated, the additional pressure from the U.S. government and regulators is unlikely to materialize in the short to the near term, but it nevertheless should be viewed as a major disruptor of the company’s business in the long term. That’s also one of the main reasons why I’m bullish on the company for now, but don’t expect it to grow at an aggressive rate forever, as the environment in which it operates changes and there’s always a risk that by the end of the decade it would be required to spin-off or face more pressure.
More Pressure From The European Union Is On The Way
In addition to facing pressure from U.S. regulators, Google is also experiencing troubles across the Atlantic in Europe, its second-biggest market. Back in 2017, the company was fined €2.42 billion by the European Commission for abusing its search engine dominance by giving preferences to its own shopping services over others in the European Union and was required to pay the fine in full after losing the appeal in the EU Court.
At the same time, back in 2018 Google received another fine of €4.34 billion from the EU Commission for the illegal practice of giving the phone manufacturers Android licenses only if they agreed to pre-install the company’s applications on those phones. The company appealed the decision, but last month the EU Court ruled that the company indeed broke the EU laws and ordered it to pay €4.125 billion in fines instead of the original sum of €4.34 billion.
On top of that, Google is also likely to lose another €1.49 billion appeal next year for once again abusing its market dominance. If the company indeed loses the third appeal next year, then in total it would owe the European Union over €8 billion in fines, some portion of which is already paid.
What’s worse is that last week it was reported that the EU Commission is preparing new charges against the company over its digital advertising business and it’s likely to fine Google at the beginning of next year. If that happens, Google is more than likely to appeal the decision but could lose it in the EU Court once again, as it’s the case with the previous appeals so far.
However, that’s not the end of the bad news for Google in Europe. Just last week, the EU Commission finally published the full text of the Digital Markets Act, which is new legislation that aims at leveling the playing field by stripping the gatekeepers such as Google from their dominant position in the digital world. A 60+ page document outlines the rules with which gatekeepers need to comply in order to continue to operate in the European Union. Some of the rules are similar to the ones over which Google was fined in Europe in recent years. In one of my previous articles on Google, I stated that the adoption of the Digital Markets Act is a formality at this stage, as the EU Parliament along with the EU Council agreed with the EU Commission on the document before, and the legislation will enter into force in less than two weeks on November 1.
What’s important to note is that the fines that the gatekeepers face if they violate the new legislation are undoubtedly harsher than anything that Google faces in the United States. Article 30 of the Digital Markets Act states the following:
1. In the non-compliance decision, the Commission may impose on a gatekeeper fines not exceeding 10 % of its total worldwide turnover in the preceding financial year where it finds that the gatekeeper, intentionally or negligently, fails to comply with:
(a) any of the obligations laid down in Articles 5, 6 and 7;
(b) measures specified by the Commission in a decision adopted pursuant to Article 8(2);
(c) remedies imposed pursuant to Article 18(1);
(d) interim measures ordered pursuant to Article 24; or
(e) commitments made legally binding pursuant to Article 25.
2. Notwithstanding paragraph 1 of this Article, in the non-compliance decision the Commission may impose on a gatekeeper fines up to 20 % of its total worldwide turnover in the preceding financial year where it finds that a gatekeeper has committed the same or a similar infringement of an obligation laid down in Article 5, 6 or 7 in relation to the same core platform service as it was found to have committed in a non-compliance decision adopted in the 8 preceding years.
In my latest article on Google, I’ve published my discounted cash flow (“DCF”) model in which I assumed that Google would be able to generate ~$290 billion in revenues in FY22 and ~$325 billion in revenues in FY23. If those assumptions proved to be correct, then in the most aggressive scenario Google could be fined up to $29 billion in 2023, which accounts for up to 10% of its global sales in FY22 if the European Commission decides that the company is not complying with the Digital Markets Act. At the same time, there’s also a risk that in 2024 the European Commission might decide that Google once again is not complying with the Digital Markets Act and place a fine of up to $65 billion, which accounts for up to 20% of its global sales in FY23 if my assumptions are correct.
Obviously, such examples could be considered too extreme and it’s hard to imagine that that’s exactly what’s going to happen, but the Digital Markets Act nevertheless gives the EU Commission the power to decide whether gatekeepers comply with the new rules or not. Considering the fragile relationships between Google and the EU Commission, there’s always a possibility that the company could be one of the first to be negatively affected by the new legislation. The only positive news is that even if the EU Commission decides to impose such extreme fines, Google would still be able to appeal those potential fines in the EU Court, which could take years before any sum of money would actually be paid, as it’s the case with previous appeals.
The Long-Term Prospects Are Not As Attractive As Investors Might Think
Just a couple of days ago, 43 European online companies sent a letter to the EU’s top antitrust watchdog, which stated that Google continues to abuse its dominant position in the market despite getting fined for it a few years ago by the EU Commission. Those businesses ask the EU regulator to enforce the European rules and at the same time allege Google of already violating the articles of the upcoming Digital Markets Act. If that’s the case, then it’s possible that Google could indeed become one of the first companies that have potentially failed to comply with the Digital Markets Act and face a fine of up to 10% of its global turnover next year.
On top of that, Google also faces $25.4 billion in damages in the Dutch and British courts, while Epic Games and Match Group are looking of adding Google to their lawsuit for the violation of Section 1 of the Sherman Act.
At the same time, Bloomberg in August reported that the DOJ is preparing to file a second complaint against Google on claims that it illegally dominated the digital ads market, while the latest rhetoric of the GOP Congress candidates signals that the voices against the Big Tech in the Senate are likely to increase after this year’s midterm elections.
All of this shows that Google is facing an unprecedented attack both from public institutions and private firms, and given the latest developments, it becomes obvious that with each passing year it would become harder and harder for Google to keep its dominant position in the digital advertising market and in the search business in particular. Therefore, its long-term prospects are not as bright as they once were.
The Bottom Line
Additional fines along with a potential forceful break up of parts of Google’s businesses are without a doubt could be considered a worst-case scenario for the company and its shareholders. While my DCF model in the previous article showed that Google’s shares trade at a discount of up to 40% from the fair value and could appreciate in the short to the near term, there’s no guarantee that its stock would be as attractive in the future as it’s now if antitrust watchdogs continue to slowly disrupt its business.
The good news is that the majority of regulatory risks are unlikely to materialize in the following quarters, so the shares could be considered a bargain at the current levels. However, in the long term, there’s a real possibility that growth opportunities could dissipate. Therefore, investors shouldn’t expect the company to continue to grow at the same aggressive rate as it did in the pre-Covid-19 period, as everything points up to the fact that the environment in which the business operates is changing and with it new rules are being implemented that are unlikely to benefit Google in the long run.
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