Editor’s note: Google’s advertising and device businesses powered record revenue and profits for Alphabet in 4Q16, reports Technology Business Research Analyst Jack Narcotta.

HAMPTON, N.H. – With a surge in digital advertising revenue and the emergence of Google as a legitimate competitor in the smartphone market fueling revenue and profits for Alphabet in 4Q16, it is clear that Alphabet’s long-term success hinges not on moonshot hardware, services, research or science initiatives in its Other Bets segment, but rather its more terrestrial businesses.

Digital advertising, smartphones and connected devices such as the Daydream View virtual reality headset and Amazon Echo-competitor Google Home will play larger roles for Alphabet as Google, the largest company in Alphabet’s menagerie, seeks to gain even greater scale in the digital advertising market, foster greater user engagement by expanding Google’s array of services and improve the quality of the “Google experience”.

Alphabet’s 4Q16 earnings, in which it generated company-record revenue and profits, illustrate Google’s lock on the digital advertising market, and demonstrate Google’s ability to transform increased smartphone user engagement into advertising opportunities for brands, marketers and content creators. Alphabet’s revenue, gross profit and operating profit surged 22.2%, 17.2% and 23.4% year-to-year to $26.1 billion, $15.4 billion and $6.6 billion, respectively.

Google’s total advertising revenue climbed 17.4% year-to-year to $22.4 billion in 4Q16, also a record, as it remained entrenched as the internet’s default keyword search service and YouTube entices traditional advertisers onto Google’s digital video platform. While Alphabet does not provide detail for its hardware business – it is lumped into a catch-all “Other Revenues” segment – TBR believes the sales success of the nearly-universally acclaimed Pixel smartphone helped lift Other Revenues segment revenue 62% year-to-year $3.4 billion.

The anticipated proliferation of Google Home in light of demand for Amazon’s Echo and Echo Dot devices, and a burgeoning portfolio of Daydream-powered virtual reality content optimized for use with mobile devices will also fuel this segment’s future performance, creating substantial non-advertising hardware revenue streams for Google that provide strong tie-ins to purchases Google Play apps and content, as well as serving as hubs for subscription services such as YouTube Red and Google Play Music.

Creating synergy between advertising platforms, apps and devices is top-of-mind for Google

Even as Google dominates in desktop search advertising and its mobile advertising business appears to be a similar juggernaut, Google has yet to fill gaps not only in the advertising experience across multiple devices, but across multiple desktop and mobile apps. Google and other advertising platform providers have been perplexed as to how to create persistent experience and information repository as users switch from PC to mobile device to connected device, or from Twitter to YouTube to Candy Crush. For Google and its advertisers, the ability to assess the impact of cross-device and cross-app consumer behaviors on their brand messaging is critical to their success.

In 2016, Google expanded the programmatic advertising services of its DoubleClick portfolio, the mobile application advertising platforms such as Android and AdMob and enterprise marketing analytics such as Google Analytics 360 Suite, driving significant year-to-year revenue gains for the company. With the digital advertising pivoting even more towards marketing to specific individuals based on their app and device usage, Google announced the following in January 2017 as it moves to bridge its hardware and advertising ecosystems:

  • All Chromebooks manufactured and sold in 2017 will support Android apps, expanding the addressable market for advertisers and Google services;
  • Google acquired Fabric, Twitter’s app developer platform, to gain insight into user-level behavior of the social network app;
  • Tighter integration of cross-device Search data with YouTube’s ad inventory

Aside from Nest’s smart home products and Verily’s life science research, Alphabet’s Other Bets moonshots are falling back to earth

Despite Other Bets’ 10.3% narrower operating loss compared to 4Q15 – the segment recorded a loss of $1.1 billion in 4Q16 – Chief Financial Officer Ruth Porat is moving quickly to rein in investments into areas Alphabet has deemed non-essential or underperforming. Segment revenue of $262 million was an improvement of nearly 75% year-to-year, but it is clear Alphabet intends to protect itself and its advertising profits from the impact of continuing to allocate expenses to support cutting-edge research and niche hardware and services.

Evidence of the deceleration of investments into pre-revenue initiatives was particularly evident as the following transpired in January

  • Alphabet announced that it will begin moving employees of the Titan team, its solar-powered drone program, to different projects and shutter the Titan program;
  • Published news reports surfaced that Google is seeking to divest its Skybox satellite business;
  • Alphabet spun off its self-driving car unit into a standalone business, named Waymo, aimed at turning the unit towards profitability by focusing on selling software, platforms and sensor packages to automobile manufacturers in lieu of competition directly with them.

These moves come on the heels of Alphabet’s 3Q16 announcement that very-high-speed-internet Fiber service deployments were proving too costly and time consuming, leading Alphabet to trim planned Fiber deployments to four cities and potential deployments to eight cities.

TBR believes these moves within the Other Bets segment signals that Porat’s initiatives to champion financial discipline in these wild-ranging businesses are taking root.

TBR expects investments into these areas to continue, particularly such as Fiber or other alternative internet delivery services designed to connect more devices that transmit user information and usage habits, but the amount of financial and human support allocated to these initiatives will be pared back to better align with the incremental revenue produced.