Google is Catching Apple
by Mark W. Hibben
Android Device Growth Continues to Accelerate
In its Q3 earnings conference call held on October 13, 2011, Google management revealed that over 190 million Android devices had been activated to date. This includes phones, tablets, and “pocket tablets” by Archos and Samsung that are positioned to compete with iPod touch. Overall, Apple’s iOS devices continue to lead the market share race, with Apple announcing over 250 million iOS devices shipped as of the most recent quarter. But the trend is clear, Android is catching up to iOS, and seems poised to overtake iOS in the next few quarters. Mobile devices now contribute about 20% of Google’s total revenues, and the explosive growth of Android and other mobile devices will only increase this percentage in the years to come. What this bodes for Google and its competitors will be the subject of today’s Tech Chat, as I offer updates of the Mobile Device Population and Google financial models, and financial projections for the next quarter.
Mobile Device Population Model
Perhaps in recognition of the confusion caused by last quarter’s conference call in which somewhat conflicting claims were made regarding activation rate and total Android activations (see my article for Google’s last quarter results), Google management pointedly refrained from discussing activation rate, merely stating that total cumulative activations had exceeded 190 million. At least this is an unambiguous number, as was last quarter’s announced activations of 135 million. So, the number of Android activations grew by about 55 million for an average activation rate over the quarter of more than 600,000 per day. As the chart on the next panel shows, the trend is becoming all too clear.
As I have done in the past, I assume some replacement rate (10% for devices activated in 2010-2011), so that the current population of Android devices is somewhat less than the cumulative activations, about 176 M versus 190 cumulative activations. Similarly, the iOS device population is derived from Apple’s device shipment data, which they provide every quarter in their financial reports. I generally assume that a replacement rate of 10% kicks in one year after product introduction, so the current population of iOS devices is estimated to be about 235 million versus Apple’s announced total shipments of “over 250 million” as of their conference call on October 18, 2011. Estimating current device populations as opposed to shipped devices is essential for the Google financial model, since it depends on the number of devices in actual use.
Not included in the mobile device tally are Google’s Chromebooks, which I don’t expect ever to become a significant population center for mobile devices. Chromebooks appear to be a Hail Mary attempt to salvage some revenue from Google’s Chrome OS effort: Chrome OS netbooks that do even less than Windows netbooks for roughly the same price. During the conference call, Google management expressed a willingness to pare down unprofitable endeavors. Let’s hope they follow through on that pledge.
As a new feature of my quarterly review of Google’s financial performance, I’m providing a projection of mobile device population growth as of the end of Q4 2011 (October-December). Cumulative iOS device shipments are projected to be 289 M for an iOS device population of 270 M. Cumulative Android device activations are projected to be 253 M for a device population of 233 M. As can be seen from the chart, I expect Android to continue to close the gap with iOS. These device population projections serve as the basis for revenue and income projections discussed later in this article.
Revenue and Cost Model Updates
As explained in Android Profitability, Revisited, Google revenues directly depend on the number of devices that can host Google ads and sites. These devices include desktop and laptop personal computers (PCs independent of OS), and mobile devices. I currently only count iOS and Android mobile devices since other mobile devices such as Symbian phones offer very limited browsing capability, and the number of Windows 7 Phone devices appears to be negligible. The average revenue Google obtains per device is currently estimated to be US$ 4.89 per quarter, upwardly revised from my previous quarter’s estimate of US$ 4.83. This estimate is applied to all devices regardless of type, even though there probably is some variation by type. Despite some probing by analysts in the Q3 conference call, Google management refused to shed any light on the percentage of revenues derived from mobile devices. The model estimated revenue is just the average revenue per device multiplied by the total population of devices (PC, iOS, Android) for a given quarter. As can be seen in the chart on the next panel, this “flat rate” revenue model gives very good agreement with Google’s revenue actuals.
Based on the growth of iOS, Android, and PC devices, and using the revenue estimate per device of US$ 4.89 that I used in the current quarter, I have estimated Google’s revenues for the various device categories, as well as total revenue, for Q4 2011. I estimate that Google’s revenue will be US$ 10.2 B with the mobile device contribution to revenue increasing to 24%.
Google’s Revenue Cost, which includes Traffic Acquisition Cost, is directly proportional to revenue, and therefore revenue costs for PC and mobile devices should also be proportional to the respective revenues. The Q1 decline in revenue cost appears to have been erased in the Q2 results, and this has been confirmed in Q3, indicating that it was indeed a short term aberration rather than a long term trend. The general trend is that revenue and revenue cost rise proportionately to the increase in the worldwide population of mobile and personal computers.
As in the case of the revenue model, I have also provided model based projections of revenues for Q4 for each of the device categories and for total revenue cost. Total revenue cost is projected to be US$ 3.6 B in Q4.
Using this approach to model Google’s other major cost categories such as G&A, Sales and Marketing, Research and Development has been more problematic. These categories are less tightly linked to revenue and inherently more discretionary. In the past I’ve made the argument that if Google are “living within their means”, then these cost categories should scale with revenue and therefore device population, and this appears to be true as a long term trend, although quarter to quarter variations remain, subject to Google management decisions regarding “investments” in future business.
Despite Google’s continued hiring, General and Administrative cost appears to scale the best with device population and revenues, as the chart below shows.
Once again, I project Q4 spending based on the long term trend line to be US$ 0.7 B.
Since Q4 2010, Sales and Marketing cost has been diverging from the trend line, indicating heavy “investment” in future growth. In Google’s most recent 10Q, they acknowledge that support to Android partners is booked under S&M, and I rather suspect that the care and feeding of the Android ecosystem is taking the lion’s share of the cost in excess of the model, which was US$ 184 M as of Q3.
As in the other charts, I extend the model predictions into Q4, but without much hope that Google will rein in their Sales and Marketing. Therefore, I’ve added a “Projected S&M Cost” based on extrapolation of their current spending trajectory. I project S&M cost to be US $ 1.3B in Q4.
Likewise, R&D spending is subject to Google management decisions regarding future technology investment. The most important technology that Google is investing in is Android. With Chrome OS dying with Chromebooks, and the Chrome browser having become a mature product, Android is Google’s main bet for future growth. The forthcoming Android 4.0 (Ice Cream Sandwich) indicates that Google is investing heavily in Android, as it should. The R&D cost in excess of the model estimate was US$ 121 M in Q3.
Once again, I provide a model extrapolation into Q4, and a “projected” R&D cost, assuming some continued divergence from the trend line. Google’s excess R&D spending has tended to proceed in a somewhat staircase fashion as Google pauses to take stock of R&D progress and determine future direction. My projected R&D spending for Q4 is US$ 1.45 B.
In the chart on the next panel, I compare Google income from operations actuals vs. the model as well as provide model estimates of income for each of the device categories. Since the beginning of the year, Google’s net income has fallen below the model estimate as it spends heavily on Sales and Marketing and R&D.
The model also estimates Android income from ops to be US$ 292 M for Q3. However, if most of the excess S&M and R&D cost is attributable to Android, which is likely, then the picture is not so rosy. If 80% of the excess cost went to Android (US$ 244 M), then the income drops to a mere US$ 48 M. Probably Google are running Android as close to break even as they can reasonably get, since they know they have to win the market share battle.
My Projected Income for Q4 reflects my expectation that Google will continue to spend heavily on Android, so that the Projected Income of US$ 3.18 B is well below the model estimate of US$ 3.43 B.
Winning the War for Mobile Internet Supremacy
While still too early to declare a victor, my strong intuition is that Google will ultimately triumph. This is as much based on their business model as it is on current trends in device population. Google’s business model is much more similar to Microsoft’s as the purveyor of operating systems for devices that others manufacture.
Such a model offers much greater consumer variety, as well as commodity level pricing. However, I don’t expect iOS to be overwhelmed by commodity Android devices the way the Mac was overwhelmed by Windows PCs in the Eighties and Nineties. In mobile devices, the superior hardware-software integration that Apple provides is more advantageous, and Apple’s pricing on their devices is also much closer to commodity level due to outsourcing as well as high volume of sales. However, I do expect Apple’s market share to be steadily eroded as Android becomes dominant in the lower cost portion of the smart phone market.
This expectation is largely conditioned by what I’m seeing in Apple management’s current decision making. Apple management have made it very clear that they intend to continue on the path established by Steve Jobs, but what they really need to do is “think different”. Jobs himself was not a dogmatist, and often demonstrated great flexibility and adaptability to market conditions (and personal conditions), as well as a willingness to take risks. A slavish adherence to what they think Jobs would do is not what Apple management need right now.
The big loser right now is Microsoft, whose Windows Phone is being shot to pieces in the Google-Apple cross fire, and nothing Nokia has shown is going to change that. Nokia may well rue the day it hired Stephen Elop. Microsoft will make inroads in the tablet space with Windows 8, however, so they may be willing to stay the Windows Phone course at least for another year in hopes of a turnaround.
Meanwhile, Google is poised to unleash the Galaxy Nexus, which will one-up iPhone 4S in almost every hardware category, as well as offer the hopefully more refined Android 4.0. As long as Android 4.0 offers some improvement (which is likely), Google will have demonstrated that even the high end of the market offers no safe refuge for its competitors.