Innovation and Real Options at Alphabet

This week, Larry Page and Sergey Brin officially stepped down from their management roles at the company they founded, Alphabet. Sundar Pichai will now have full control of the company, while Larry and Sergey will advise from time to time, while retaining majority control. (Alphabet is the parent company of Google, its best-known business. Alphabet includes many other, smaller business activities in addition to Google’s famous search business.)

The reaction to this turn of events has been interesting to observe, particularly the response of the financial community. Numerous analysts praised the change, because they saw Alphabet’s spending as being too high, particularly with Other Bets, the organizational box in which Alphabet reports its non-core business activities. With Larry and Sergey gone, the thinking goes, this waste of resources can be brought into line, and shareholders will benefit. The stockmarket response also seemed to confirm this line of thinking, with Alphabet’s stock moving up 1.9% according to Bloomberg as the news hit the market. 

I worry that the market has it wrong, or more precisely, I worry that the market is being too myopic in its assessment of Alphabet, particularly its Other Bets. At the most basic level, some analysts appear to assume that all of the money being spent in Other Bets is simply wasted, that nothing of value is being created. (Alphabet reported that its Other Bets lost $868 million in FY 2018, on revenues of $595 million). At another level, the many activities going on in Other Bets, from Calico, DeepMind, GV, CapitalG, X, Google Fiber, Jigsaw, Makani, Sidewalk Labs, Verily, Waymo, Wing and Loon operate in wildly different businesses, and many analysts appear to simply ignore whatever business success they are having. This is deeply anti-innovative thinking.

A better way to think of these Other Bets is as Real Options. An option is the right, but not the requirement, to take an action at a later time. So you can buy an option on oil for $100 a barrel. If the price of oil jumps up above $100 a barrel, this option is “in the money”, and becomes valuable. If oil prices remain where they are today, the option is “out of the money”, and worth nothing. Options are great tools for managing risk (in this case, the risk that oil prices spike). They don’t cost much to create, and some of the time they become worthless. But other times, they can create a lot of value.

You don’t value options based simply on their current income. You value them based on the underlying volatility of the risk you are trying to manage, relative to a risk-free rate of return. So the fact that Other Bets cost Alphabet $868 million last year says almost nothing about whether these options are going to be in the money or not. In a typical venture capital fund, for example, the first five years of the fund are spent investing in a portfolio of startups, and the last five years of the fund are spent trying to achieve liquidity events (“exits”) for each of those portfolio companies. After the first five years, the income statement of a venture fund would be highly negative, with a lot of investment made, and little revenue coming out. But there may be one or more great businesses in the portfolio that will emerge with a little more time. Indeed, Google Ventures and Capital G are both venture funds for Alphabet that are reported as part of these Other Bets.

And the operating businesses in Other Bets have had some events that show that some business value is indeed in the process of being created. Verily, a life sciences Other Bet, received a $1 billion investment last year from Silver Lake Partners, a savvy private equity investor. We don’t know the exact terms of this investment, but with some simple assumptions, we can show why this might be a valuable option for Alphabet to have. Assume that Silver Lake got half of the venture for its $1 billion investment. Assume that Silver Lake strives for a 10x return within 10 years in making this investment. That suggests that Silver Lake expects its investment to be worth $10 billion, making Alphabet’s remaining stake also worth $10 billion. Over ten years, Alphabet’s stake would be worth $1 billion per year, more than covering the total loss for Alphabet on all of the Other Bets, if this option ends up in the money.

Waymo is another Other Bet, and is acknowledged by many industry analysts to be among the leaders in autonomous driving software. How much value is that worth? It is hard to be precise, but clearly that option is worth billions of dollars. We could go through this exercise with each of the Other Bets. Not all of them will be in the money, but a portfolio of such options is an incredibly valuable asset to have, and the total value of the options in the Other Bets is far, far more than the current period losses reported by Alphabet. Yet the financial analysts demanding that Alphabet’s spending on Other Bets be cut appear to ignore this.

Perhaps this is a trading opportunity: any purchaser of Alphabet stock gets a claim on the impressive profits of Google’s search business, with a bonus portfolio of real options on exciting future businesses thrown in for no extra cost!  More seriously, innovative companies like Alphabet need to create and manage real options for their future businesses as part of how they innovate. Because no business, however profitable, lasts forever. And the time to write those future options is when the current business has the profitability and momentum to cover their short term costs. 

In this view, Larry and Sergey weren’t wasting shareholders’ money with these Other Bets. Instead, they were thinking innovatively, building an amazing real options portfolio of future businesses for themselves, along with the other Alphabet shareholders. Sundar should take note, and manage these options for the innovation and latent value they may possess, rather than cut all the spending on them now.

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