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The Google iPhone search dilemma. It’s a doozy

May 17th, 2017 |  Published in Google and the World

Traffic acquisiiton costs


17 May 2017 – At my readers know, every February I attend the Mobile World Congress in Barcelona (run by the GSMA). It is an enormous event: 5 days; 110,000+ visitors: 2,900 exhibitors; 167 educational sessions, etc., etc. It is exceeded only by the “mega” event I attend at the end of the year, the Frankfurt Book fair: 7,300 exhibitors, around 275,000 visitors, more than 4,000 events.

But the GSMA offers a whole range of events around the world beyond just Mobile World Congress. These are set in smaller settings, fostering regional engagement at a strategic level. Subjects are the economics of the mobile industry, privacy and security of mobile devices, “next generation” IoT, etc. These are excellent networking opportunities and an ability to zero in on 1 or 2 subject areas. Oh. Sorry. Did I mention the wine tastings?

I just came back from one such session and one of the presentations was by Fivesight Research, a company that does some high-level analysis into tech, telecom, and media. Their analysis was on Google and mobile search and they came out with these nifty points:

  1. Mobile search is driving growth in Google’s core business.
  2. Google’s Traffic Acquisition Costs (TAC) for mobile search is higher than desktop search and has been increasing since Q1 2016.
  3. Apple accounts for a large portion of these TAC costs based on all the mobile search traffic it generates for Google.

NOTE:  a traffic acquisition cost (TAC) consists of payments made by Internet search companies to affiliates and online firms that direct consumer and business traffic to their websites. Traffic acquisition costs (TAC) are a critical cost of revenue for Internet search firms such as Google, Yahoo and TAC for these firms is watched by investors and analysts to ascertain whether cost of traffic acquisition is rising or declining. Rising TAC has a detrimental effect on profitability.

The result is shrinking margins for Google and increased vulnerability to Apple. According to Fivesight Research, Google needs to seize control of mobile search by further developing the Pixel line of smartphones.

Now Alphabet recently reported outstanding Q1 results with virtually all key financial metrics pointing in a positive direction. But one item caught that caught the attention of Fivesight Research was the increase in Traffic Acquisition Cost for Google distribution partners. TAC was 10.4% of site revenue, up from 8.5% in the prior year period. This isn’t a one time blip, but a continuation of a long term trend and it is disturbing on two counts:

1) it equates to lower profit margins and

2) it means Google’s financial engine is reliant on iPhone generated search traffic.

TAC chart

Ruth Porat, Alphabet’s CFO, has been warning investors of the increasing TAC and associated margin contraction, attributing it to the growth of mobile search. Here’s what she said about mobile search on the Q1 earnings call:

The biggest contributor to growth again this quarter was mobile search, reflecting the secular shift to mobile due to the greater utility of smartphones for users and advertisers.

That’s the good news: mobile is driving growth in Google’s core search advertising. The not so good news is that mobile is more costly, requiring higher TAC payments to Google’s partners, the major one being Apple. Of course, Porat carefully avoided mention of Apple in her remarks on the TAC trend:

As we discussed in prior calls, even though mobile revenue growth requires an increasing investment in the mobile ecosystem in the form of higher TAC, our strength in mobile search is adding meaningfully to profit dollars. And we do expect Sites TAC to increase as a percentage of revenues. But again, our focus continues to be on growing profit dollars. And I think the main point is we’re very pleased to have a very strong business in a rapidly growing area, and that’s benefiting our profit dollars even as the TAC percentage increases.

Apparently the resulting margin contraction — glossed over by Porat — doesn’t bother Google as long as absolute profit dollars are increasing. That may be fine for now, but it should be a warning sign for investors and Alphabet management especially since a major beneficiary of TAC payments is Apple.

What it boils down to is this: a higher fraction of searches are coming from mobile and of these a significant — though undisclosed — portion come from iPhones. And Google pays Apple TAC for all of these searches. So Apple, a major competitor, is a catalyst and significant contributor to Google’s growth in its core business.

Does this give Apple important leverage over Google? Yes, and as it continues to marginalize — but not prohibit — Google from search access points on the iPhone, there could ultimately be a reduction in Google search traffic from Apple customers.

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