Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) recently reported outstanding Q1 results with virtually all key financial metrics pointing in a positive direction. But one item caught my attention: the increase in Traffic Acquisition Cost (NYSE:TAC) for Google distribution partners otherwise known as Sites TAC. In Q1 Sites 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.
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 (NASDAQ:AAPL). 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.
In this light it puts more pressure on Google designed phones as a counter to Apple. I expect to see Google expand the Pixel line, perhaps with announcements coming this week at i/o. At the same time, it needs to continue to cultivate the Android ecosystem of OEM partners. A difficult balance, but Google has no other choice.
And Apple has its own dilemma. It’s reportedly earning $1 billion+ from Google TAC payments in exchange for making Google the Safari default and thereby driving its competitor’s growth. How does Apple play this? The $1 billion is a nice revenue stream, but one that Apple could forgo if it wanted to. But iPhone customers, like the majority of all smartphone and desktop users, strongly prefer Google when it comes to search. So, Apple can’t do anything rash like it tried a few years ago when it removed Google maps, causing a huge customer backlash. But replacing Google as the default on Safari? Maybe.
Apple has clearly demonstrated its desire to move Google to the periphery by using Bing as the default on Siri and Spotlight search. And there’s no doubt Microsoft would covet winning the default on Safari. Will Apple take this step and install Bing as the Safari default? If it does so, it loses the TAC but succeeds in dealing a blow to a bitter competitor by reducing Google search volume from the iPhone customer base.
It’s impossible to know how this will play out at the moment given the secrecy surrounding the Google/Apple search arrangement but we should learn more at Apple WWDC June 5.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.