Alphabet (GOOGL -3.39%) (GOOG -3.43%) is about to get much more profitable. The company's management team has given some not-so-subtle clues about this major change in its approach to the "other bets" segment going forward, but it doesn't seem like the market has fully caught on yet.
CEO interview
In a recent interview with Fortune magazine, CEO Sundar Pichai was asked whether investors should expect the company to instill more investment discipline regarding the company's "moonshot" projects in the "other bets" segment now that he's been named CEO of Alphabet. For context, the "other bets" segment has reported an operating loss of almost $11 billion over the last three years and more before that. Some of the businesses within "other bets" have enormous promise, including autonomous car technology leader Waymo, but investors have been given no road map regarding the future profitability or how or when shareholders will benefit from these businesses.
Pichai responded affirmatively, saying, "It's a direction we had already gotten under way," that investors "will see me focused on that more and emphasize that more," and the company is "at a phase where, while we take a long-term view, we also want to marry that with the discipline of making sure they are doing well."
Image source: Google.
That's a big deal. For years, the company's message to investors emphasized the importance of taking a long-term view with these moonshot projects, and funding them with plenty of capital. For example, in 2016, CFO Ruth Porat commented about the "other bets" segment by saying, "Long-term success requires a commitment to making bets, putting the right talent and resources behind those bets, and remaining flexible and dynamic as we pursue them." Clearly, the tone has changed with the company now tightening its belt with respect to its moonshot projects. Investors should expect these "other bets" losses to narrow this year and beyond.
Comments on the fourth-quarter conference call
These sentiments continued on the company's fourth-quarter conference call. Porat said, "In 'other bets,' we are sharpening our focus on the metrics and milestones against which capital allocation is determined, and we continue to assess where external capital is additive to governance and execution." In other words, the company isn't just going to throw more money at these ventures without carefully considering their progress and whether they actually merit greater investment. And rather than go it alone with all these ventures, the company intends to partner with more industry participants who can pony up part of the investment capital required.
There is precedent for this. Alphabet's life sciences moonshot company, Verily, has already partnered with outside investors Silver Lake Partners, Singapore's Temasek, and others.
This approach lines up with Pichai's comments in the Fortune interview. Asked if he would seek outside investors for additional Alphabet entities, Pichai said, "We expect most of the 'Other Bet' companies to follow a process like that over time."
CEO's incentive compensation package
This increased cost and investment discipline regarding the "other bets" businesses should reduce the segment's operating losses and therefore increase the whole company's operating profits. And partnering more "other bets" businesses with outside investors should reduce the amount of money Alphabet will need to invest in these businesses over time. To the extent management follows through on these intentions, the combination of higher profits and less capital required will accelerate Alphabet's free cash flow growth.
In case you're wondering if management is going to follow through on these steps, consider how the company is now compensating Pichai. In December, the company's board of directors approved a new compensation arrangement with Pichai where most of his compensation is tied to the total shareholder return of Alphabet over the next two and three years. Alphabet's management team has always taken a very long-term view, and it still is for the most part. But the company's CEO has never been so financially incentivized to increase free cash flow and have the stock price outperform in the near term. Investors would be wise to take notice.
