By now, it's no secret that Microsoft (MSFT -3.21%) has launched a fresh effort to go after Alphabet's (GOOG -1.94%) (GOOGL -2.03%) cash cow.
Shortly after OpenAI launched ChatGPT last November, reports emerged that Microsoft was aiming to launch its own ChatGPT-powered version of its Bing search engine. Microsoft confirmed those rumors earlier this month when CEO Satya Nadella unveiled the new Bing at a presentation with OpenAI CEO Sam Altman.
Nadella declared that "a new race" had begun in search and AI.
Image source: Microsoft.
A financial war of attrition
Alphabet responded to the Microsoft announcement the next day, unveiling its own competitor to ChatGPT -- called BardAI. The launch was poorly reviewed, and Alphabet stock price fell 12% over the two-day period as investors seemed to realize that ChatGPT posed a real threat to Google's search empire.
It's still early in the race to define the next iteration of search, of course, and either company, or another one entirely, could end up winning, but one comment from Nadella shows why Alphabet could lose even if it wins the race.
In an interview with the Financial Times, the Microsoft chief described his strategy in the new search battle, saying that he expected a financial war of attrition in the category as competitors will have to spend heavily on the AI computing power required to run chatbots like ChatGPT, and he was content to accept losses in order to take market share from Google.
Nadella described the competition with Google as "asymmetric," saying: "There is such margin in search, which for us is incremental. For Google it's not, they have to defend it all." He also predicted, "From now on, the [gross margin] of search is going to drop forever," because computing costs will significantly rise to use AI.
Monopoly money
Alphabet has long held a monopoly in search, with greater than 90% market share in most of the world outside of China. The company's massive profits in search underpin much of the rest of the business and subsidize money-losing segments like Google Cloud and other bets, which include "moonshot" projects like Waymo, its autonomous vehicle subsidiary.
Monopolies are known for generating bumper profit margins, and that's certainly true for Google Search. While Alphabet doesn't break out profit margins specifically in Google Search, Google Services, which receives nearly two-thirds of its revenue from Google Search, reported an operating margin of 34% in 2022. It's likely that the margin in search is even higher.
While that margin shows how strong the Google Search business is, it also makes it a target for the competition. Amazon founder Jeff Bezos famously said, "Your margin is my opportunity," and Nadella seems to spy a similar opportunity in the new battle with Google.
Winning the search market won't come down to pricing the way it does in retail. Instead, Nadella seems to envision a contest to build the most sophisticated AI-based search engine, and that will be expensive.
Nadella also wisely recognizes his own company's advantage as a disruptor here. Microsoft can easily afford to burn cash on Bing to grow its market share. For Alphabet, on the other hand, any incremental spending to defend its market share will have an impact on its profits because search represents such a large percentage of the company's bottom line.
What it means for Alphabet
Nadella can't single-handedly dictate the future of search, but as the chief of one of the few tech companies that can go toe-to-toe with Alphabet on its home turf, his proclamation about gross margin erosion is like to be spell trouble for the Google parent.
Microsoft has already invested $10 billion into OpenAI, and the company is clearly ready to spend aggressively on the new Bing, as CFO Amy Hood shared in the presentation that each percentage point of market search in search is equal to nearly $2 billion in revenue. Nadella himself called search "the largest software category on Planet Earth."
For Microsoft, there's essentially only upside to waging war in search. For Alphabet, the opposite is true -- as an established monopoly, it's already at its competitive peak.
With the emergence of generative AI in search, Alphabet's traditional advantages are losing their power, and just beating back the threat from Microsoft is likely to be expensive, as Nadella argued. The company's decision to hastily rush out Bard AI also shows that Alphabet is prepared to spend to defend itself in search, though it may not win.
Considering its reliance on search, the threat from ChatGPT, and the new competitive dynamics in the industry, there's a good chance that Alphabet's most profitable days could be behind it.
