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The Silver Lining in the Google Earnings Cloud

by Mark W. Hibben
10/22/12

Really, it wasn’t all Bad News

The financial analyst community reacted negatively to the Google earnings miss with some justification.  It wasn’t merely that Google had failed to live up to their expectations, fixated as they are on the near-term bottom line.  Since the Motorola acquisition became final in Q2 2012, costs have trended sharply up, while operating income has trended in the opposite direction, as the chart below shows. 

Since Google first announced the new class of common stock at the 2012 Q1 conference call, it’s been apparent that the move was intended to ward off the consequences of near term financial set-backs, which Page and company were clearly expecting, largely as a result of the Motorola acquisition. 

As Page made clear, the issuance of the non-voting shares was intended to help preserve the control of the company by the current management team.  At the time, I noted that it seemed oddly defensive for a company doing so well, but Google management knew they were in for rough weather.  The question now becomes, when does Google emerge from the storm?

To answer that question, let’s examine the good news presented during the conference call.  Page disclosed that the rate of activation of Android devices had reached 1.3 million/day and that over 500 million Android devices had been activated to date.  These are truly remarkable numbers.  Android has become a colossus bestride the mobile world.  As of the end of June, Apple had sold a total of about 400 million iOS devices.  While Apple’s figures for the most recent quarter haven’t come out yet, I expect them to add only about 50 million more iOS devices (iPhones, iPads, and iPod Touches) to that total.  Cumulative sales or activations are not the same thing as total devices in use, since some obsolete devices are replaced and taken out of service.  In the chart above, I’ve estimated the total worldwide population (devices in use) for iOS and Android based on a modest phased replacement rate of 10%.  The Apple device population numbers are based on specific shipment data Apple publishes every quarter and so I consider the estimate fairly accurate. 

Google has been less forthcoming about specific activation numbers per quarter, sometime divulging just a rate, sometime specific total activations for the quarter, and sometime cumulative activations to date.  Google’s activation rates haven’t always been consistent with their cumulative activations, so the plotted curve represents a curve fit to the available activation data and may therefore smooth out quarterly fluctuations. 

The current quarter will mark the first time that the total number of Android devices is significantly larger than iOS devices, but note that the total of about 880 M for both platforms is approaching the estimated number of PCs worldwide (somewhere around 1- 1.5 billion), showing how important mobile has become.  Estimating the devices in use is important because Google’s advertising revenue depends on the number of devices in use, not the number sold, and for both Google and Apple, sale of a device is just the beginning of the revenue generating process.  Devices continue to generate revenue from sales of apps, digital content of all types, services and advertising, and both companies contrive to direct the attention of device users to their preferred market places.  To a large extent, Google’s advertising based revenue is device agnostic, so iOS devices contribute to Google revenue and thus subsidize Android, whereas Apple derives negligible revenue from Android devices.  Apple’s move away from Google provided services such as Maps, and eventually Search, I believe, is an attempt to remedy this situation.  

At the conference call, Page also disclosed that the mobile device “run rate”, the annual revenue due to mobile device advertising, apps, digital content, and services had reached $8 billion.  Unfortunately, Google management refuse to provide a breakdown of this number by product or device type, but it provides a quantitative metric for how important mobile has become.  The run rate represents about 20% of Google’s non-Motorola revenue for the fiscal year.  Given that the number of mobile devices is about 2/3 of the number of PCs (desktop and mobile, Windows, Mac and Linux), this indicates that average monetization per mobile device isn’t nearly as high as per PC. This only makes sense, since consumers are less inclined to use their phones for Web browsing, even when they have that capability.  Google execs were at pains to point out that further monetization of mobile represents an opportunity for innovation Google is just beginning to explore.

A Triumph of Ecosystems and Economic Models

So Android has become the dominant platform for smart phones, since phones constitute the lion’s share of Android devices, while Apple appears to be holding its own in tablets for the time being.  For calendar Q2 2012, Apple sold 17 M iPads, or about 68% of the estimated total of 25 million tablets sold.  As IDC’s smartphone market share numbers demonstrate (which I showed in my last post), Apple has all but ceded the smartphone market share battle to Google.  I acknowledge this freely as an Apple investor, fan, and iOS developer, who is enormously frustrated by Apple’s complacency in these matters.  A complacency I saw demonstrated in a comment on my last post to the effect that Apple’s continuing sale of outdated iPhones constitutes “diversification” of the iPhone product line.  When Android started grabbing serious smart phone market share in 2011, Apple needed to respond with an all-new low cost iPhone “mini”, which it simply failed to do.

Apple’s hesitancy in further diversifying the iOS product line, and the resulting negative market share consequences, point to a more fundamental disadvantage of the Apple business model compared to Google’s.  Apple’s product planning, design and production of iOS products very much resembles a centrally planned economy in miniature.  Key decisions about product direction and design are taken by a relatively small group of Apple managers.  The consortium of manufacturing suppliers Apple uses to make its products provide relatively little design input or feedback, other than to inform Apple engineers what is possible to make.  The manufacturing supply chain takes its direction from an army of Apple “supply chain managers” who virtually live with their suppliers.  These managers are there to ensure that Apple gets what it contracts for, and they are absolutely essential for that purpose.  Although the contracts are theoretically competitive, in practice, they usually are not.  Once business relationships are established and contractors (or sub-contractors) deliver the goods, everyone is reluctant to change the existing order.  The advantage of the Apple model is that Apple management call the shots on iOS products.  The disadvantage of the Apple model is that Apple management call the shots on iOS products. 

In contrast, the Android economy is much more like a free-market economy in miniature.  Google exercises only limited influence on the specific design of Android devices. 

Instead, many device manufacturers compete freely in an open marketplace for the attention of the world’s consumers.  This naturally results in greater variety and choice.  Google’s influence is limited to providing the Android OS, which, being open source, vendors are free to customize to meet their needs.  This necessarily leads to some fragmentation of the OS, a disadvantage that Steve Jobs pointed out.  The advantages of the Android economy are the traditional advantages of free markets: rational allocation of resources, open competition driving innovation, and responsiveness to consumers. 

The Motorola Experiment

The acquisition of Motorola by Google may represent an ill-advised deviation from the free market model that has served Android so well.  It’s as if Google has set up a “state owned” enterprise in the midst of its thriving free market economy, which the economy is now taxed (indirectly) in order to support.  But there is plenty of precedence for such “hybrid” economic models (China not the least), so the failure of such an endeavor is not a foregone conclusion.  Google’s current financial performance indicates that they are still struggling to make the experiment work.  Google management know they have to pare down Motorola’s staff and activities, and that costs money in the near term in severance packages, early retirement benefits, etc.  Beyond merely reducing expenses at Motorola, Google needs to bring benefits to the larger Android ecosystem in return for its support of Motorola.  This can only be through licensing of current and future Motorola IP.  There has been every indication that Google intends Motorola to become the technology incubator for the Android ecosystem, but in that role there is no certainty that Motorola can ever be profitable as a separate business unit.  In the end, Google may be forced to subsume Motorola into the larger enterprise simply to avoid having to report separate results.

Emerging from the Storm

By the end of the year, Google should have completed most of the necessary reorganization of Motorola, and the impacts to Google’s bottom line should ease, but I don’t expect an upturn in operating income to show up until the Q1 2013 earnings report.  This is the point at which I believe Google emerges from the storm, in answer to the question I posed at the beginning of this article.

It may still take a while for operating income to return to pre-Motorola levels, however, and when the larger Android ecosystem will begin to benefit materially from the acquisition is anyone’s guess.  Until the Q1 2013 report, I expect investors to continue to pare down positions in Google, with a consequent negative impact on stock price. 

  • 1. Not all Bad News
  • 2. Mobile Device Population
  • 3. US$ 8B Run Rate
  • 4. Triumph of Ecosystems
  • 5. The Motorola Experiment
  • 6. Emerging from the Storm
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