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The Google Dilemma
By all accounts, and rightfully so, Google has been a smashing success as a company. They have achieved scale, prominence, profitability and brand. However, like most every innovation that emerges, there comes a time when the landscape shifts and they must shift with it. This topic is not new, and in fact, is covered in books like The Innovator’s Dilemma. Google’s main product is “search” – or the indexing of the internet’s content and calculating the most relevant information per each request. Google makes its money by selling advertisements against that page of information/links. Search for hotels in Miami and get ads for Priceline or Hilton – simple. Along the way Google has done two main things to enhance its business: 1) continued to improve the quality of its search results and the context of the ads it shows against them (adding display as well); 2) adding a variety of other products designed to capture more of your time spent online, therefore increasing the number of searches you perform on Google and therefore data you provide Google, and also providing more page real estate to display ads -think ads on Gmail. Both of these efforts have delivered wonderful results. That is the past – that is how we find Google at the top of the tech world, commanding ~70% of worldwide search, with a growing presence in e-mail, browsing, product and travel search, and business applications.
The dilemma that Google faces centers on the rapid shift from the desktop centric world that currently dominates search and most all web activity, to the mobile environment where 1) Google does not command as high a market share; 2) the monetization (or just ASP to think of it simply) of search activity is much less and 3) consumers growing knowledge of the internet landscape and lower tolerance for search time in the mobile environment is met by the advent of “apps” – which shortcut search activity.
So what? Doesn’t Google own Android the 1st or 2nd largest smartphone platform with over 250m installed devices and a large App store (renamed Play Store)?
Yes, they do – and much credit should be given to Page and Brin for buying Android and fostering its growth. Android filled a much need void in the smartphone category. The introduction of Apple’s iOS left the RIMM’s Blackberry OS, Nokia’s Symbian, and Microsoft’s Windows looking like MS DOS. On top of the fluidity of the OS itself, was the same tactic that brought so much success to the iPod, the marrying of hardware and software to a content delivery service. The iTunes store was extended to deliver apps – bite sized nuggets of web activity or entertainment at the touch of an icon. No typing, no searching – a custom built application to deliver most of what one normally seeks on the web, without the hassle of long load times and cumbersome surfing, in addition, games became a massive draw of attention. Aside from Apple, no one delivered this type of platform or ecosystem (these words often get thrown around but have specific meanings, a more in-depth topic for later).
In stepped Android, offering full touch screen with Google integration and an app marketplace. The UI was very similar to that of Apple and the software free (aside from the cost of internal tweaks) to OEMs – it was really obvious in hindsight that Google would take massive share. As Google has continued to improve both its OS and ecosystem along with Apple it left RIMM, Nokia and Microsoft in the distance. Android has 250m devices active and posted some impressive app download numbers – and aside from the holiday iPhone4S push one would expect the future for Google to be amazingly bright given brand, adoption rates, and OEM support (particularly with the advent of lower priced Android phones penetrating the market). However, there is one large problem (aside from the Motorola deal). The web activity on a mobile device monetizes at a far lower rate than the desktop, and the software itself is free – so how is Google going to make up for the lost economics? They don’t know yet.
The answer from Google thus far alludes to the idea that they should gain as much share as possible first and figure out monetization second (you can’t tweak to a bigger audience). They feel the monetization of mobile is comparable to search circa 2002-2005. Also, they faced a similar problem with YouTube – massive activity, volumes, and growth but terrible monetization. Google has slowly ramped up the efforts and economics, but it still pales in comparison to its activity levels. However, more importantly, the activity is additive to Google, not taking away from other businesses. The mobile opportunity is more complicated than search and YouTube though – the main intent of users and and flow of information is not the same.
On mobile; there are four key points 1) traditional web and search advertising is based on click through rates which are much lower on mobile devices; 2) the type of web search activity on mobile is slightly different – as is tolerance for tangent surfing; 3) apps completely circumvent the web; 4) to date, mostly all of the money made in mobile outside of ad platforms was made by Apple, Samsung and app developers.
Positives 1) the ability to cater higher value ads related to time and location; 2) the advent of HTML5 may put more activity back on web pages possibly allowing more ads vs content pages; 3) as mobile internet users mature, and tablet like devices improve, users may organically seek out more web resources – I often compare the app vs HTML5 idea to the AOL vs Netscape transition (the walled garden was great until we had a tool to tame the outside world).
Negatives 1) the Android kernel is free – and in fact, the two software companies that make money off the growth are Microsoft and likely Oracle; 2) as a free OS, OEMs are constantly tinkering with the UI to “make it their own” – this dilutes the brand power of the OS; 3) the very nature of mobile search is more action directed than desktop and the model needs to adapt; 4) social sharing and app marketplaces are the new form of discovery and take place on the “dark web” or password protected verticals that Google can’t see, track, and calculate.
So what might Google do?
Well, we’ve already seen several Nexus phones as a way to demonstrate their capabilities and improve the brand – if they can convince OEMs to follow more standards this would help a bit. They could charge for the OS… but this goes against their philosophy, and as a free kernel it would be difficult. They are planning a Nexus tablet and have revamped the app store – now the Play Store and it shares content across mobile, tablet and desktop.
But what we really want to talk about is Motorola. Sure, the IP portfolio was important… but what do you do with the hardware piece? Samsung is the 2nd largest smartphone player behind Apple, and largest overall, and you have the best or second best OS… do you compete with them? Do you run it “separate” and hope they make money on their own like Samsung? Or do you full-on integrate and run it like Apple and tell Samsung they need you more than you need them? At the end of the day the handset business is very much like the PC business and the straight sale of commodity hardware is a no win game over the long run. What Apple does is sell a premium product, AND a premium ecosystem. Google sells neither, they give it away. Recent news flow suggests that Google will launch a Nexus tablet with Asus, and it will cost $149-199. This is essentially the Amazon Kindle market. Google has tried a similar strategy with the Chrome OS, but has not had too much success. There certainly is appetite for another tablet, but it has to come with a premium ecosystem …Android does have an ecosystem, but the branding is changing and developers are not making any money. Much work needs to be done.
There remains a level of risk to the formidable Google model over the medium and long term. In Google’s favor is the lack of competitive threat from RIMM, MSFT/NOK and others at the moment. It takes time. The negative is that any agreement to pursue Motorola with an Apple-like model may hasten other partnerships and even the potential for a Chinese OS. We think Google’s current momentum in Android will likely continue, and monetization on mobile with slowly improve. That said, it remains a core holding for exposure to the secular shifts…particularly given the sell off around the Motorola announcement…oh, and they own the information side of the internet such as maps and knowledge – which will continue to matter.
Update 4/18/2012: Business Insider reports on 4/17 that people familiar with Google say they plan to work with the Motorola division to design build and sell hardware AND software for the phone…or basically copy the Apple model. This will make for interesting discussion as Samsung rolls out S-Cloud, its iCloud and Google Drive competitor, at its May 3 Galaxy event. The addition of Motorola to the Google model will cause some ripples as Motorola is questionably profitable. In addition, tighter integration with Motorola could mean an all out Google store to sell phones and tablets (already happening with Nexus). I don’t think Samsung will get too upset yet as they are almost half of the Android market…but they will start to hedge their bets.
RIMM – Research Not in Motion
The trials and tribulations of RIMM are well documented and there is no shortage of opinions on what will become of the company and its technology. Despite the recent surge in share price, many feel that RIMM is being outflanked by Apple and Google and is rapidly losing market and mind share (in the US this is true, though they hold a stronger Emerging Market presence at the low end, taking share from Nokia). Many in the marketplace have strong convictions about what is coming for RIMM…resurgence, 3rd player, acquisition, bankruptcy. We feel it will be number 3 but only after the fourth option has crossed the minds of investors. RIMM is a damaged brand that doesn’t understand it is a damaged brand and will continue to lose market share at a rapid pace until it is worth next to nothing, save for its IP, cash, and perhaps to some competitors, its enterprise services capabilities.
Following the sort of issues laid out in The Innovator’s Dilema, RIMM was the innovative force in secure mobile email and keyboard devices. The success was self reinforcing as customers raved about the service and keyboard functionality. Enterprise IT departments praised the security, and faced little backlash for choosing RIMM as a) it was secure and b) competitive offerings were not that great. But as mobile email shifted from business perk to necessity, and consumers became the driving force of innovation and choice in the market – the winds shifted. The Apple iPhone debuted in 2007 and was the warning shot across the bow for RIMM. The response from the Canadian company was to keep making “great” RIMM devices, as expected, and they were not too terrible. But, a funny thing happened in the ensuing product iterations. As RIMM was forced to consider more and more consumer “features” and design characteristics its hardware, and software became less reliable. As we crossed from the start of the Curve series to the later iterations the software crashed more often, battery died faster, and the screen resolution and web surfing looked outdated. At this point, RIMM made one of its more fateful decisions. Instead of doubling down on consumer and enterprise software with touch screens and trying to keep up – they decided the physical keyboard was THE key feature and something consumers would keep coming back for time and again. Their early and continued success led them to believe they were right. After all, enterprise renewal rates were near 100% – they must love the devices, right? Having missed the start of touch screens and then being blindsided (like most) by the App economy, RIMM was now two generations behind and has been flailing in the wind ever since. Each successive product became a race to match feature sets of current Apple and Android models and they never created a must have new feature. Seeing dwindling unit numbers (and a majority of business consumers who can’t download apps anyway) the app developers didn’t create anything new either.
With the launch of the Storm and BB05 in late ’08 early ’09, their first all touch-screen phone – it became clear that RIMM’s brand was damaged. It’s enterprise renewals, international presence in the value segment and popular Blackberry Messenger (BBM) product (which avoids SMS text fees) have kept the share price afloat, while solid financial management keeps the street happy. But this is all beginning to fade. Market share loses in the US are increasing and lower priced Android devices are popping up in emerging markets. In addition, the budding trend of “bring your own device” BYOD, where employees use their iPhone or Android phones for personal and work is seeing massive number of Fortune 500 companies testing and deploying solutions that don’t require RIMM. Lastly, the recently announced BlackberryPlaybook which is the response to the iPad is a complete miss and highlights the current state of the company. The product is a smaller form factor, is being rushed to market with almost no app support and buggy software AND will not have email native on the device, you will need to tether your existing Blackberry. The core competitive advantage of RIMM is its secure email and messaging system – how can they not have that as a core feature?
In review: the brand is damaged, innovation is lacking, relationships with app economy are weak, core enterprise market actively testing and deploying substitutes. No matter the valuation, these are the components of a value trap stock that will drift lower over time. The remaining value will be its IP, who’s value is difficult to discern, and the enterprise services business – which is basically its secure on-premise servers and the software that manages them… this is a ~$3-4b/year revenue business. The valuation range for a services business that serves a declining hardware base is difficult to nail down… a ranger of 0.3 to 2.2x sales could be used. Clearly I would lean to the lower end for a weakening brand. At ~$2b in cash, $4b in enterprise services value and IP – its not difficult to view a much lower market value as sales trends begin to accelerate to the downside.
As trends decline, the concept of a buyout is always enticing, but recall that all potential suitors of the hardware business are a) likely working on their own solutions; b) will be wary of buying a damaged brand and c) can wait for lower valuations.
Is a turnaround possible? Yes, of course, but one of the great and unique aspects of technology is that it is a constant struggle to stay relevant, innovative and profitable all at once. The technology graveyard is littered with would-be turnaround candidates. The problem with RIMM is that once the concern reaches the brand level, the hurdle for turnaround scales parabolic. Missing a product cycle is one thing, a damaged brand is another. Given their difficulties in launching new products, their existing enterprise contracts and international presence will float the company for a while, but all incremental data shows that marginal movement is ALL Android and iOS, we see this as a terminal situation. Avoid RIMM indefinitely.
The Change Investor 