Quick Thoughts: Google’s OnHub router

It looks like a slew of reviews of Google’s OnHub router have come out in the last 24 hours or so, so I’m guessing some sort of embargo has lifted. It seems the reviews are decidedly mixed (which feels par for the course today for products both good and bad, as reviewers each seek to find something unique to say, often overreaching in search of something worth praising or criticizing). Glenn Fleishman has an interesting review of reviews of sorts at TidBits, which is  worth reading for its own sake and for the links to other reviews.

What I wanted to write up here quickly isn’t a review (I don’t have a review unit) but some other related thoughts I’ve had about the OnHub router since it was announced, and which have been reinforced by reading some of these reviews. We discussed some of this on the Beyond Devices Podcast a few weeks back, the week the router was announced, but I’ll probably go a bit deeper on some of it.  I’ll embed the podcast episode at the end of this post too.

A router for novices at a power user price

One of the things that struck me off the bat, but has really been brought home by these reviews, is that there’s a fundamental mismatch between the price positioning of this router and the target audience. The whole value proposition (at least for today – and we’ll come back to this) of this router is that it’s enormously simple to use. And yet it’s priced at $200, the same sort of range as the high-end routers in the market. The Wall Street Journal review notes some interesting trends in the router market, which I think serve as useful context for this device:

Cable companies and other Internet service providers now rent their customers basic Wi-Fi routers when they sign up for service. As a result, U.S. router sales have fallen from 6.1 million year-to-date in 2012 to 3.5 million in the same period this year, market research firm NPD reports… NPD determined that the average selling price is on the upswing. Cheap routers aren’t selling so well, but higher-end models… are. “People are willing to pay a lot of money—more than before—for an AC router with significantly better performance than they had in the past,” said Mr. Baker.

Here’s the thing: I’m betting that the kind of people who are willing to pay a lot of money for “an AC router with significantly better performance” are not the kind of people who feel intimidated by those routers. They’re the kind of people who know enough about routers to understand what distinguishes 802.11ac from some of the older technologies, and who are likely pretty comfortable customizing the various settings. And yet Google’s router is priced in this same range and yet removes many of the typical settings available to power users in other routers in that category. You can’t specify separate SSIDs for the 2.4GHz and 5GHz bands, you can’t get into a web interface, and many of the other deeper settings you can configure on almost any other router. This is a router for novices sold at a power user price point. As such, it’s likely to please neither group.

This is further reinforced by the fact that the router is clearly something of a trojan horse for Google in the home automation space, given the inclusion of Bluetooth and Zigbee, and yet again those users are likely to want far more control over their routers than the OnHub provides. Some of this may be solvable in software down the line, but I suspect Google’s whole mentality around this router is wrong, and that can’t be fixed by software updates.

A symbol of Google’s disjointed approach

To my mind, the OnHub router is also a symbol of Google’s disjointed approach to so many of its projects, and I worry that the Alphabet reorg will only make things worse. Google already has a home automation business, Nest, which not only makes its own products but has been the vehicle for both making further home automation acquisitions (Dropcam) and for acting as a hub for other home automation gear (the Works with Nest strategy). And yet, this product isn’t branded Nest, nor does it apparently sit under Tony Fadell’s hardware group, which also includes Google Glass. In fact, Mark Bergen of Recode and Amir Efrati of the Information have both suggested that this product actually came out of the Google Fiber team. I’ve written previously about how disconnected from the rest of Google the Fiber project has seemed, and it’s ironic to now see Google proper appropriate this technology just as Fiber is being hived off into a separate Alphabet company. The good thing about Google is that people throughout the organization feel free to experiment with various things, some of which eventually become products. The bad thing is that this means you could have several separate teams working on similar things in isolation, and in some cases you end up with several products apparently chasing the same use case (e.g. the Nexus Q, Chromecast, and Google TV/Android TV).

The naming of the OnHub router, the subdomain on.Google.com, the naming of the companion app (Google On), and so on all suggest that this is the beginning of a broader strategy (and we already know that there will be another router made in partnership with Asus). But this is yet another effort within Google to tie together the different devices in the home. Why isn’t it owned by Nest? How will it relate to Android TV and Chromecast, Google’s other living-room projects? So many questions, and so few answers…

The theory and the reality

One other thing Google has touted as part of its positioning for the OnHub is this idea that it is pretty enough to sit in the living room. This, too, feels like a very Googley statement – I’m not sure how many people with real design sense would actually want even a relatively good-looking router in their living rooms. But it’s also a bit of a non-starter as a practical matter – the router doesn’t stand alone – it needs both a power cable and an ethernet cable to function, and you’ll seldom find both of those in the middle of a living room. You’ll at least have power outlets in the wall, but your cable modem is likely to be in a closet somewhere rather than in your living room. And with only one jack in the back of the device, you’re going to need a switch somewhere else anyway for the rest of your hardwired devices, another example of the mismatch between functionality and pricing.

I could go on with all this, but you get the idea. Though an interesting product, the OnHub feels like it falls short on the theory alone, let alone the reality (where several of the reviews suggested it falls down too, even on the most touted features). But it also feels like it’s emblematic of several of the key challenges Google has – too many experiments and projects that are poorly coordinated, poorly thought-through, and ultimately poorly executed. I’m not convinced that the Alphabet structure will help with any of this, and in fact it’s quite likely that it will make the fragmentation problem worse rather than better.

Lenovo’s tough quarter

Lenovo reported this week that it had just concluded a tough quarter, and was going to be taking actions to streamline its business and operations, including laying off a significant number of employees and cutting costs in the mobile business in particular. This post runs through some of the components of Lenovo’s tough quarter and examines where the business is likely to go from here.

Note: this is my second post on Lenovo – the first was on its Q4 2014 results, the first it reported after acquiring Motorola. Please note also that in this post as elsewhere on this blog I use calendar quarters for ease of comprehension and comparison, even when companies’ fiscal years are different.

Motorola has been a great defense against shrinking sales in China

I believe the Motorola acquisition was originally contemplated as a way for Lenovo to build scale and especially to break into some new markets. However, it’s turned out to be a phenomenal defensive strategy against some significantly worsening trends in Lenovo’s largest smartphone market, China. As part of Lenovo’s quarterly results presentation, it shared these numbers – sourced to SINO – on smartphone sales in China, and they provide a great context for Lenovo’s problems domestically (this is my chart, based on the same numbers):

SINO China smartphone dataThere are two important trends to note here: firstly, total sales (shown in red) have declined in the past year; secondly, subsidized sales (shown in blue) have declined even more strongly, and are shrinking as a share of total sales. The fact that the Chinese smartphone market is shrinking is bad enough, but Lenovo is particularly exposed to that carrier-subsidized segment, which is rapidly going away as carriers discontinue subsidies under pressure from the government. The result is that Lenovo’s Chinese smartphone sales are shrinking rapidly:Lenovo China smartphone shipmentsLenovo’s smartphone shipments in China peaked at almost 14 million in Q3 2014, and have fallen steadily since, to just under 5 million in Q2 2015. Were it not for the addition of Motorola’s smartphone sales, Lenovo would have seen a serious dent put in its overall sales. As it is, things don’t look quite so bad overall from a shipment perspective, though sales have still declined over the past two quarters:Lenovo total smartphone salesWithout the Motorola business, Lenovo’s smartphone shipments overall would have fallen from 15.8 million in Q2 2014 to just 10.3 million a year later.

But Motorola is also dragging down profits

The problem is that, while Motorola’s shipment numbers have been a great benefit to overall shipments, its financials continue to be a drag on the business. It’s hard to isolate Motorola’s performance within the overall numbers reported by Lenovo, but there are hints when you look at Lenovo’s operating margins by geography and by segment, where Motorola’s results disproportionately affect the Americas and Mobile respectively:Lenovo margins by geographyLenovo margins by segmentNote: Lenovo changed its reporting segments in Q4 2014, and as such we’re missing operating income by segment for Q3 2014 until it reports them with Q3 2015 figures next quarter.

As you can see, both the Americas and the Mobile segment saw significant declines over the last few quarters as Motorola joined the company. Economic conditions in Brazil particularly impacted the Motorola business but also affected other parts of the business, so that’s part of the reason for the sudden drop in Americas margins. However, Motorola was unprofitable when it joined, and it continues to be so. In fact, Lenovo just subtly changed its profitability target from having the Motorola business be profitable in 4-6 quarters after acquisition to having the total Mobile segment of which Motorola is a part be profitable, a recognition that it’s going to take longer to turn the Motorola business around.

In PCs and tablets, growing share in shrinking markets

I’m not going to spend as much time on PCs and tablets as on smartphones, but I did want to note that in these two categories Lenovo’s challenge is a bit different. The markets themselves are shrinking, so even though Lenovo’s share of both markets is growing, that’s not delivering strong growth overall. In fact, PC shipments dropped several percentage points year on year, while tablet shipments only grew modestly. If growth trends in the PC market continue to worsen, even Lenovo’s significant outperformance of the market won’t help it, while its tablet sales are too small to help offset the challenging conditions in smartphones and PCs.

Lenovo’s proposed solution is familiar

We’ve heard it so many times over the last several years from different Android vendors that Lenovo’s proposed solution to what ails it in in the smartphone market is very familiar: streamlining and simplifying the product portfolio, while making the smaller number of models more compelling and better differentiated. Samsung, HTC, LG, Sony and others have all embraced this strategy over the last few years, and while it’s likely a good idea, none of those companies have seen significant turnarounds as a result, and all continue to struggle to a greater or lesser extent in selling smartphones.

However, Lenovo is also taking some other steps to turn its performance around, cutting its workforce, and moving to what sounds like single sales and product organizations. Interestingly, it’s largely focused on the Lenovo sales organization (though it’ll presumably keep some Motorola staff on in key markets like North America where Lenovo has never had a presence), and the Motorola product design, development, and manufacturing organization. Earlier, it was cautious about consolidating the two manufacturing organizations in particular, and it’s intriguing to see the company consolidating around the Motorola function rather than the Lenovo equivalent. It will be interesting to see to what extent the Lenovo and Motorola brands continue to be marketed distinctly if both sets of devices are coming from the same team.

At the same time, Lenovo is also embracing new channels domestically, mimicking Xiaomi in its pursuit of the online model with the launch of the ShenQi online store this past quarter and the ZUK Z1 phone in August through that channel. This makes tons of sense given the shift in purchasing from one channel to the other, but it’s not yet clear that Lenovo has the competencies required to pull this model off.

There are also hints in Lenovo’s press release that it might seek to acquire other PC businesses as a way to further grow scale while driving cost efficiencies. The key quote here is:

Accelerating the drive for 30 percent share in PCs by better taking advantage of consolidation, while becoming even more efficient and reducing costs to ensure sustainable, profitable growth.

That may mean something else, but it certainly sounds as if it could be referring to an acquisition strategy in the PC market.

Where does Lenovo go from here?

Given the tough domestic conditions, it’s going to be hard for Lenovo to turn its performance in China around dramatically, which makes its rest-of-world strategy all the more important. But though the addition of Motorola made for favorable year on year comparisons, the Motorola business itself actually shrank year on year in terms of shipments, from 7.7m in Q2 last year to 5.9m this quarter. Motorola has had real success with its low end devices, the Moto E and Moto G, but that success has come to a great extent in certain markets that are now facing challenging conditions too. Brazil is perhaps the best example – Lenovo sold just 167,000 smartphones there in Q2 last year, but the combined company sold around 2.5 million smartphones there in Q2 2015, and yet this turned out to be something of a liability this quarter as conditions worsened. Latin America as a whole accounted for 3.7 million shipments, and if the economies there continue to struggle, that likely doesn’t bode well for Lenovo.

With these headwinds in key markets like China and Latin America, Lenovo needs to do better in other regions, but those regions are relatively small for the company today, with just 1.4m shipments in North America and 2.8m in EMEA in Q2. Lenovo is heavily dependent on the BRIC countries, which account for over 60% of its smartphone shipments today. And yet the Motorola brand has been struggling in the US, its erstwhile stronghold, for several years now. What’s selling is the low-end smartphones, with an average selling price for Lenovo as a whole of a little over $100, and Motorola’s ASP around $200.

I’ve been quite bullish about Lenovo until now, but at the moment I’m less certain on its prospects for the short to medium term, especially if things don’t change domestically. But Lenovo isn’t alone in this – it’s been caught up in the perfect storm that’s affecting many of the major Android vendors, and that’s been causing a number of them to announce significant cuts in their businesses in recent weeks. The good news is that PC margins continue to be relatively healthy (at least in the context of the broader Windows PC market), and PCs represent the majority of Lenovo’s business today. But if Lenovo really wants to follow through on its strategy of becoming a major player across these device categories, it’s going to have to find a way to turn its smartphone performance around.

Thoughts on the new AT&T

AT&T this morning held a conference for financial analysts in Dallas, at which it outlined both its strategy and its financial guidance following the closing of the acquisition of DirecTV a few weeks ago. The event was live-streamed, and the slides from the various presentations are available to download from this page (where I assume a replay of the conference will be available shortly too). In this piece, I’ll share my thoughts in some depth about some of the key announcements, and briefly hit a few highlights on some other items towards the end, before wrapping up with my conclusions on the prospects for the new AT&T.

Note: for broader context on the TV business that’s central to much of what’s below, see my post yesterday on cord cutting, which provides subscriber growth trends for the largest US pay TV providers.

Putting the new AT&T in context

Firstly, I think it’s useful to put the new AT&T in context, among the other large players it competes against. Here is the combined subscriber count for AT&T in the various retail categories it competes in (note that I’ve used retail wireless subscribers, which excludes connected cars, MVNO subscribers and other categories where AT&T isn’t selling directly to end users):ATT subscriber countsAs you can see, this is a formidable company at this point, with large numbers of subscribers across these different categories, with wireless by far the largest base. Verizon is the largest carrier by retail subscribers, with around 110 million, putting AT&T second, and far ahead of T-Mobile and Sprint. But in pay TV, AT&T is now the leader in both the US and the world, a dramatic change from its former position (note that “New Charter” represents the combined subscribers of Charter, Time Warner Cable, and Bright House following their merger, if successful):Pay TV subs post mergersThis combined scale, at almost five times AT&T’s previous standalone scale, is one of the two key benefits from the merger, and is something I’ll come back to below.

Cost synergies are significant, especially around content

The true definition of synergy is when two things come together and are greater than the sum of their parts, whereas the term is often used to mean cost savings that result when two things come together (indeed, AT&T talked up $2.5 billion of run-rate synergies from this deal, and that was entirely about cost synergies). However, AT&T also talked about the positive synergies that would come from putting these two businesses together, and they gave us some very interesting specifics around these.

On the cost synergy side, there are two major categories – content and operations. The content savings will come largely from the fact that AT&T can now leverage that combined scale in content buying – John Stephens (AT&T’s CFO) said during the conference that AT&T’s U-verse customers cost $17 per sub per month more for TV content than DirecTV’s customers. That obviously presents huge opportunities for reducing spend on content over time, and those savings make up a good chunk of the overall synergies. The other big chunk comes largely from consolidating operations across the two companies, getting to a single installation model and so on.

Revenue synergies could be far greater

However, to my mind the revenue synergies are much more interesting, and we got some interesting detail there too. AT&T broke out some of the cross-selling and up-selling opportunities as follows:

  • Of the 57 million households AT&T passes with its broadband service today, only 13 million have U-verse, and only about half could receive U-verse TV, whereas all 57 million could be sold TV now as part of a bundle from AT&T
  • 15 million households have DirecTV but aren’t AT&T Mobility subscribers, and so could be sold mobile services from AT&T
  • 21 million AT&T Mobility subscribers don’t take TV from either DirecTV or AT&T today, and so could be sold TV services
  • 3 million households in AT&T’s landline footprint have DirecTV but not AT&T broadband.

I’m actually somewhat skeptical of the benefits of a double play that simply combines TV and wireless, because it’s missing the broadband piece. As such, the two middle bullets there seem less compelling to me than the other two, which both involve a more traditional (and likely more appealing) bundle of TV and broadband. Landline/wireless bundles have never been popular, in part because they tend to offer small cost savings and little integration and in part because they make for very high monthly bills that many consumers would rather take in two chunks. In addition, the value proposition of a bundle that offers everything but broadband is not that appealing when customers still have to go to the local cable company for broadband, and are likely to pay more for it on a standalone basis than as part of a bundle. The reality is that the broadband/TV bundle is the one most people want to buy, and AT&T has good opportunities to cross sell these two products, and that’s the most interesting part of this to me.

Hints at new products and services

One of the most intriguing things to me was several hints from executives that new products, services, or ways of delivering existing services would be coming at some point in the future. Some of the things that were hinted at included:

  • Going over the top with a video service. There were several references to providing video over both managed and unmanaged networks, and the context was such that this didn’t seem to just be talking about TV Everywhere-type extensions to classic services. I’m very curious to see if this means we’re going to see either DirecTV or U-verse branded video services being sold to subscribers that can’t or don’t want to buy the traditional services from either company.
  • Providing optimized video services for AT&T Mobility customers. The implication here – especially given a comment about being in compliance with merger conditions – was that AT&T might offer its mobile subscribers some special access to U-Verse or DirecTV content, or possibly use the Sponsored Data model AT&T already has in place to provide zero-rated access to this content.
  • New business models for TV Everywhere authentication and sharing. There were lots of references to millennials using their parents’ pay TV login details to watch linear TV without their own subscriptions, and the opportunities to use the Mobile Share model to deal with this. That, to me, implied some sort of model under which TV subscribers would pay on some sort of per-device basis for additional streams, such that AT&T would monetize this sharing of credentials. I wouldn’t be surprised if we see more of this kind of thing from pay TV players and content owners going forward. However, TV Everywhere solutions already have a poor reputation for usability, and AT&T made portability of content a huge selling point today, so I’d expect them to tread carefully with this.

A realistic view of trends in TV

One of the things that was most refreshing about the AT&T executives’ comments during the morning was that they seem very much on top of the actual trends in the industry and not afraid of articulating them, even those that don’t necessarily bode well for traditional players. The excerpt below is from my on-the-fly notes (no transcript is available yet) based on John Stankey’s remarks on trends in the TV industry:

Pure play standalone offerings increasingly challenged. OTT will continue to grow and mature as a distribution alternative to managed networks. % of cord cutters, shavers and nevers will continue to grow. Premium content will migrate to OTT and skinny bundles. As these things occur, traditional TV advertising moves to other forms, pressuring content providers especially those with smaller audiences and less compelling content.

That seems to me both a decent summary of the trends and threats facing the traditional TV industry and a frank assessment of the implications. It’s good to see that AT&T isn’t in denial about all this (in contrast to some recent remarks from other players in the industry) and that it’s factored these trends into its projections for the combined business. In the Q&A at the end of the day, Randall Stephenson dealt with some questions on this and basically said that yes, pay TV was going to decline, but slowly, and that AT&T thought it could both grow fast enough to offset that market decline, and adapt its offerings so as to achieve similar profits off smaller TV bundles if necessary. That’s easier said than done, but given the details above about cross-selling and up-selling, it doesn’t seem too far-fetched, at least for the time being.

Two other quick notes

I don’t want to go into too much detail on this stuff, but a couple of other things were worth noting:

  • AT&T’s new advertising platform and products. AT&T has now combined its old AdWorks unit with the DirecTV advertising platform, and can offer both the scale of DirecTV and the local targeting capabilities of U-verse (and will use LTE where necessary to provide targeted advertising to DirecTV subscribers). It’s interesting to see both AT&T and Verizon investing in cross-platform advertising, albeit in very different ways (Verizon through its AOL acquisition).
  • John Donovan’s segment on AT&T’s technology platforms. John Donovan has been one of the best additions to the AT&T executive ranks over the last few years – he’s presided over a major overhaul of AT&T’s technology operations over the last few years, and that transformation is still going. During the conference, he talked through how AT&T is trying to match and then compound the benefits of Moore’s Law as it seeks cost efficiencies in network performance – it’s well worth a watch.

The new AT&T’s prospects

There’s so much more to talk about, and I haven’t even touched on AT&T’s Latin American strategy. But I just wanted to take a step back and summarize my view on AT&T as a company. I’ve said previously that when it comes to the mobile business, AT&T is the company most focused on what’s next. It began investing in connected cars, home automation, and a variety of other businesses years ago and is now reaping the benefits of its early start, capturing a significant share in connected cars in particular and driving significant net adds through that business. Even as the traditional phone business is saturating, AT&T is tapping into new growth areas better than its competitors, and that’s been important as its own traditional growth has slowed.

Today’s event, though, highlighted the fact that AT&T is still perfectly willing to compete in traditional areas too – the pay TV business in the US, and traditional phone services in high-growth markets like Mexico. Of course, that means exposing itself to some of those negative trends in TV, and Mexico is arguably just a few years behind the US and will eventually hit the same sort of saturation that the US has. However, in the US, its focus in the consumer market is going to be about putting together the different components of its offering in new and different ways. I expressed skepticism above about double play wireless-TV bundles, but I’m much more bullish about AT&T expanding its share of broadband-TV bundles in the AT&T footprint, especially as that footprint expands. At the same time, AT&T’s evolving technology foundation should give it the infrastructure it needs to pursue these opportunities with increasing cost efficiencies, while improving the end user experience. And on the business side, it’s continuing to build what’s arguably the strongest set of global assets for pursuing enterprise customers.

That’s a heck of a lot of moving parts, and there’s plenty of places for things to go wrong, but I’d argue that AT&T is easily the best positioned of the US carriers given its combination of assets and its strategy, and if it can execute well it should have a really good few years ahead of it.

An update on cord-cutting

The last of the major pay TV, broadband, and phone companies has now reported, so we have a pretty good sense of how the industry fared in Q2. As I do every quarter, I’ve put together a series of charts on the industry for subscribers to the Jackdaw Research Quarterly Decks service. As usual, there’s been tons of press about cord-cutting lately, but so often numbers that are bandied about only tell part of the story, so I wanted to provide an update with as much transparency as possible about where these numbers come from and what they represent.

A lot depends on what you measure

The reality is that this was a down quarter for the pay TV market, almost no matter how you look at it. Some of the numbers people report only provide a partial view, whereas I look at three discrete groups of companies in my reporting:

  • Major Public Players: The largest publicly-traded cable, satellite, and telecoms providers, a group that includes AT&T, Cablevision, Charter, Comcast, DirecTV, DISH, Time Warner Cable, and Verizon. These companies account for a large majority of overall pay TV subscribers in the US, but by no means all of them.
  • Public Players: A longer list of publicly-traded companies in those categories, which adds Cable ONE, Consolidated Communications, Frontier, Mediacom, Suddenlink, Windstream, and WideOpenWest to that list. This list gets even closer to covering the whole market, but is still not comprehensive. However, it doesn’t rely on estimates, and so is the most robust of the sets of numbers in its mix of comprehensiveness and foundation in actuals.
  • Public Players plus Cox and Bright House: That list plus estimates for two other companies: Bright House and Cox, the two largest privately-held cable companies, which don’t report their subscriber numbers publicly. I’ve used a combination of my own estimates and those provided by companies like the Leichtman Research Group to fill in these gaps. This longest list still isn’t utterly comprehensive, but accounts for the vast majority of US TV subscribers, though it relies on some estimates.

In the charts below, you’ll see these groups denoted as “big players”, “all players”, and “incl. Cox/Bright House” respectively.

A down quarter, no matter how you look at it

However, no matter which of these three groups you look at, it’s clear that the industry had a poor quarter, and arguably its second in a row. What’s important to note about this industry, however, is that it’s extremely cyclical, and the second quarter is usually the worst quarter of the year. As a result, I tend to look at year on year comparisons because that eliminates the cyclicality somewhat. The three charts below show net year-on-year changes in pay TV subscribers for the three groups described above:Year on year video adds big playersIf we look first at the “big players”, the trend is already obvious: year on year growth is well down on all the quarters in the past two years, albeit still marginally positive. But of course these numbers don’t include the smaller players, which often lose subscribers to the big ones. When we wrap those numbers in, we see the following:Year on year video adds all playersAs you can see, now we’re suddenly talking about a real decline year on year, and not just slowing growth. Those smaller players between them lost quite a few subscribers, and when they’re factored in we see a more complete picture. However, we’re still missing the two privately-traded companies, but based on past numbers and extrapolation we can add a reasonable estimate for them, too:Year on year video adds including Cox Bright HouseAnd now we see that this is not the first, but the second, quarter of negative growth for the industry. And you can also see that the trend started a year ago, as year on year net adds began declining then and have fallen every quarter since. Behind all this, though, is a series of interacting dynamics between the various groups of players in the market – cable companies, satellite providers, and telecoms operators. The results for these different groups are shown below:Year on year video net adds by categoryWhat you can see here is that the cable companies have actually been doing better over the past year or two, reducing their total net losses from 1.5 million to 1 million in that period, while the telecoms operators’ growth has slowed much more significantly, falling from 1.5m year on year to just over five hundred thousand. As the two major satellite providers have also seen a combined slowing of growth, the net result is that the industry has contracted for the last two quarters. There’s a little short-term stuff in here – last quarter AT&T focused on profitability in its TV base and actually saw a slight loss in subscribers, while Verizon’s marketing was constrained by its legal scuffle with content providers over its Custom TV bundles. So it’s possible we’ll see some recovery next quarter for the telecoms side of this business. But it’s increasingly clear that this is a zero (or negative) sum game, and that if telecoms gains do grow, they’ll likely come at the expense of the cable companies.

Household context worsens the picture

However, things can get even worse. The US population isn’t static, of course – the number of households is actually growing fairly rapidly, so that even static TV subscribership would mean falling penetration. Even the change from 2013 to 2014, when subscribers grew, represented a slight reduction – around half a percentage point – in penetration. And the last six months, with real year on year shrinkage, just accelerates that trend. We’re somewhere around 79% penetration at the moment, but it’s likely that this number is likely to fall by around 1% or so per year over the next few quarters. Cord cutting really is happening at this point, and it will only accelerate as more and more alternatives to the traditional pay TV bundle become available. That’s not to say it’s going to go to zero – there are still lots of barriers to adoption of alternatives, not least sports programming – but for many users, the alternatives are becoming good enough, especially as cable mainstays like HBO become available outside the bundle.

Making sense of Google’s Alphabet move

This afternoon, Google announced a restructuring of its business which will eventually see the current core Google business sit as a subsidiary within a new parent company called Alphabet. Google’s blog post about the move is here, and the SEC filing with some additional details and legalese is here.

Berkshire Hathaway remarks in context

This move finally puts the comments Larry Page made recently about Berkshire Hathaway in context – I wrote about those remarks previously here. As a reminder, Page had said to some shareholders that he saw Berkshire Hathaway as a model for Google to emulate, and in that piece I wrote about all the ways Google isn’t like Berkshire Hathaway, and why that model would be wrong for Google, and yet here we are facing the prospect of a conglomerate called Alphabet owning Google and a variety of other unconnected businesses.

The reasons for the move

There are two ways to explain this move. The first can be described as personal: Larry and Sergey have quite clearly been increasingly uninspired by merely running a search engine and advertising business, and this finally aligns their job titles with what they actually want to spend their time doing. It also gives Sundar Pichai a well-deserved promotion and presumably prevents him from leaving for a CEO job somewhere else. However, it would be an irresponsible thing to do to restructure a company as huge as Google simply to give three individuals the jobs they want.

Hence, we have to look at financial reasons, and I think there are a couple of them here. Firstly, this is kind of like Amazon’s recent AWS move in reverse. When Amazon broke out AWS in its financial reporting recently, it took a small but rapidly growing part of the business that was buried in the overall financials and allowed it to shine in its own right, rather eclipsing the core business in the process. Google has to some extent the opposite problem: its core business is massively profitable, but it has a growing number of non-core businesses which are masking its true performance. By breaking out the core Google business and the rest in its financial reporting, Google allows the core business to shine (I’d expect that core business to have better profitability and potentially growth numbers than Google as a company reports currently). By contrast, it will finally become clear quite how large and unprofitable all the non-core initiatives at Google are, which might well increase pressure from shareholders to exit some of those businesses. I suspect that the positive reaction in the stock market to today’s announcement is a sign that Larry Page and others have signaled to major shareholders that something like this would be happening.

The other financial reason is that separating subsidiaries in this way loosens the organizational structure and allows much easier addition and subtraction of those entities – in other words, acquisitions and spinoffs. Until now, any large acquisition contemplated by Google had to be absorbed by the core business or awkwardly separated out as Motorola was during its brief time at Google. Neither is ideal, but allowing acquisitions to sit in an “Other” bucket at Alphabet corporate level while leaving Google intact and separate might be a more attractive way of managing acquisitions going forward. At the same time, any subsidiary that either becomes so successful that it’s worth spinning off as its own company or comes to be seen as non-core is much more easily disposed of because it’s already operating somewhat independently.

A conglomerate needs an investment strategy

As I mentioned in that earlier piece, one of the biggest problems with seeing Google as a conglomerate is that it doesn’t share one of the key characteristics of other conglomerates: its subsidiaries are able to operate independently. Yes, it’s clear that Larry Page wants Google’s various subsidiaries to be operationally independent, with their own CEOs making decisions about their businesses, but it’s also clear that in the vast majority of cases they won’t be able to financially independent. In other words, those CEOs who are supposed to be independent will be going cap-in-hand to Alphabet management every quarter asking for more money to fund their operations.

But to my mind the bigger issue is that, as Google shifts from being a single company to a conglomerate, a mission statement such as organizing the world’s information needs to be replaced by an investment strategy, and it also needs an investment manager. One of the defining characteristics of Berkshire Hathaway is that it’s very transparent about the principles on which it’s managed (see the Owner’s Manual written by Buffett in 1999). Its management is both highly skilled in making investments but also highly focused on achieving specific financial goals with those investments. By contrast, it’s not clear that Larry Page or any of the other senior managers at Google has this skillset, or that there’s any investment strategy here other than doing things that Larry and Sergey find personally interesting or “important and meaningful” (to borrow the phrase they use in the blog post). That’s a poor guide to an investor as to how to think about the company and its financial performance going forward. The restructuring won’t happen until later this year, but one of the things that Google’s management will have to do between now and then is explain what their investment strategy is.

A quick note on transparency

I’ve seen some people suggesting that Google will provide more reporting transparency as a result of this move. That’s true, but only insofar as Google will now report the part of the company that’s still called Google as a separate entity from the rest. As Mark Bergen reports at Recode, only Alphabet and Google will report their results – the rest will presumably just be in a big pile called “Other”. I’d assume that the Google segment will continue to break out the Google Websites, Network, and Other buckets as at present, but anyone hoping for more data on the performance of Android, YouTube, or other bits of that Google business will likely be disappointed. It’s going to continue to be as opaque as it always has been, I suspect.

A deep dive on Microsoft’s Q2 2015 numbers

Following Microsoft’s earnings is always interesting, because like any other company it releases many of the key data points in its press release, but to a greater extent than others it releases lots more little details in its regular quarterly SEC filings. And once a year, the 10-K provides an additional set of very interesting data. As such, I often hold off on writing analysis of Microsoft’s earnings until all these details are out. This piece builds on past pieces on Microsoft’s earnings, in some of which I’ve laid out the methodology I use for calculating some of the revenue numbers for individual businesses. Last year’s deep dive following the release of the 10-K is here.

Note: here as elsewhere on this blog, I use calendar quarters rather than companies’ fiscal quarters in my commentary and in charts. The only exceptions in this piece are specific references to Microsoft’s fiscal years (denoted as FY 2015 etc.)

Because this is a longer post, I’ve provided some links to specific sections below:

Employee numbers paint a stark picture of the Nokia acquisition

I’ll start with some of the stuff that Microsoft only reveals once a year in the 10-K, and that’s employee numbers and a product-level breakdown of external revenues.

From an employee perspective, the overall number is always interesting by itself, but this time around I found the categorization of the workforce particularly interesting. The three charts below show this split both by job function and by geography.

This first chart gives you some sense of the overall numbers as well as how they break down. As you can see, the workforce two years ago was just under 100k, but a year later it was almost 130k. What happened? The acquisition of Nokia’s devices business (NDS) is the main answer. But of course, since the acquisition Microsoft has pared back that workforce quite a bit. As I wrote in my piece on the Nokia impairment a few weeks ago:

By the time it’s done with the layoffs announced today, Microsoft will also have jettisoned around 80% of the employees associated with the Nokia acquisition. It took on around 25,000 (down from the 32,000 originally anticipated) when the acquisition closed, but laid of around half three months later, in July last year. Now, a year later, it’s losing another 7-8,000, taking the remainder down to just 5,000, or 20% of those originally brought on board.

Some 25,000 of that 29,000 bump from June 2013 to June 2014 was Nokia-related, but by June 2015 the number was back down to 118,000, or 10k lower, but that’s the net impact after hiring in other areas. The most dramatic impact from a job function perspective was manufacturing and distribution, which is shown in light blue at the top of the columns below, and is broken out separately in the second chart below. It’s also worth noting the strong growth in the Product Support and Consulting category during the last two years – this is organic hiring to support some of Microsoft’s newer businesses, and it’s accelerating rapidly. The third chart shows a geographic breakdown, and there too you can see the dramatic impact of the Nokia acquisition on overseas employees (up 25,000 exactly from 2013 to 2014) and subsequent loss of 8,000 of those employees a year later.

Stacked employees by functionEmployees by function Employees by geographyProduct revenue breakdowns

I always do quite a bit of reading between the lines every quarter to establish estimated figures for various product lines, but once a year Microsoft gives us a breakdown of “external revenues” from major product lines. This is about the only way to build a complete picture of products like Windows and Office, which are otherwise spread through Microsoft’s various reported segments. The chart below shows this breakdown on a stacked basis:External revs by productAs you can see, reported revenues have grown strongly for each of the last few years. However, these aren’t pro forma figures: the acquisition of NDS isn’t factored into past years’ revenues, so both in FY 2014 and in FY 2015 Microsoft got an artificial bump from NDS (in 2014 only for a very short period since the acquisition closed late in the year, and in 2015 for a full year’s worth of revenues). If you compare 2015 to 2014, you can see that Surface and Phone by themselves accounted for essentially all the growth in that period. Strip out the Phone business alone and revenue would have been roughly flat. But underneath that, there’s actually a lot going on too, as the year on year growth rates below show:
Year on year growth
Xbox is easily the spikiest of these revenue sources, rising and falling with new product releases as you can see in 2011 and 2014. Windows has seen the most dramatic fall, from strong growth in 2010 to flat growth the next few years and now negative growth (in part, but not entirely, due to currency effects). Office, too, has seen a steady decline and shrank this past year. Server Tools and Products and Consulting and Support services are the most consistent growth drivers for Microsoft at this point, while Advertising has also contributed strong growth most quarters (and the rate of growth will increase with the disposition of the display advertising business). What’s interesting to me, though, is the paucity of information about the sale of the display ad business to AOL – the only references to it label it as outsourcing of the business to AOL and AppNexus, but there’s no discussion of the impact on revenues going forward or anything else. My past calculations – shared in that earlier post linked to above – suggest that this business was worth just under a billion dollars a year, so it’s not nothing. The omission of any discussion of this impact in the 10-K feels odd.

As a result of all this, the two historical mainstays of Microsoft’s business – Office and Windows – make up an ever smaller proportion of the company’s revenues. If you take the PC version of Windows alone, that and Office now account for just 41% of Microsoft’s revenues, while adding in Server Products and Tools brings the total up to 61%. Obviously, the addition of NDS is a big reason for the drop off the last two quarters, but as we saw above Windows and Office are also shrinking in their own right.

Windows and OfficeLastly, it’s interesting to note that Microsoft did indeed hit a milestone I had predicted they would this time last year: international revenues have now eclipsed domestic revenues for the first time in Microsoft’s history, at least on an annual basis, though the transition probably happened sometime in the second half of FY 2014.
US vs international rev

Cloud revenue, AWS, and growing margins

Last quarter, when Amazon first broke out AWS revenue separately, I wrote a piece comparing Microsoft and Amazon’s respective cloud revenue buckets, and provided all kinds of caveats about the limits to the comparability of these two businesses. Here, then, is an update based on information in the 10-K:MS cloud and AWSEssentially, the pattern from last quarter continued – AWS remained just a little ahead of Microsoft’s “Cloud Services” reporting line this quarter, and for the last four quarters was just ahead at a hair under $6 billion, compared to just under $5.8 billion for Microsoft. Interestingly, though cloud services are not one of the product lines Microsoft breaks out in the numbers I analyzed above, they are broken out just below that, rounded to $5.8 billion, and Microsoft says they’re reported in several of those segments that are reported.

Unfortunately, unlike Amazon, Microsoft provides no good sense of how profitable this business is. The only small hints are references to data center spending sprinkled throughout the 10-K. They include this interesting snippet in a description of Microsoft’s main drivers of expenses:

Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, datacenter costs in support of our cloud-based services, and income taxes. (emphasis added)

Further along in the 10-K, we get another mention of data center costs, which apparently rose by $396 million in FY 2015. Given that cloud services revenues rose by $3 billion in the same period, that’s almost nothing. Obviously, data center costs aren’t the only expenses associated with cloud revenue, but they have to be one of the largest. In FY 2014, by contrast, data center costs rose by $575 million, while revenue rose by $1.5 billion, so the return on that investment is increasing significantly. Gross margin in the bigger segment that commercial cloud services are part of (Commercial Other) rose significantly – by $2.3 billion or 126% – in FY 2015, much of which was due to Office 365 growth at enterprises, as well as growth in Azure. Total cost of revenue in this same broader segment only grew $946 million, or 17%, so it’s clear that Microsoft is hitting its stride in terms of achieving economies of scale and higher margins, though it’s still elusive exactly what level those margins have now reached.

A broader look at margins

If we take a step back and look at that larger segment, Commercial Other, we can see that gross margins are rising steadily, and are now above all the other non-software categories at this point:

MS gross margins by segmentLicensing continues to have the highest gross margin – cost of sales are tiny compared to revenues in that business since the incremental cost of an additional sale is close to zero. But Commercial Other, composed primarily of cloud services and enterprise services, is becoming increasingly profitable, and with its growth is also becoming an increasingly important contributor to overall margins. It’s at around 9% of gross margins now, up from under 2% at the beginning of 2013, and growing fast. Commercial licensing continues to account for the lion’s share of gross margins, at 64.5%, while consumer licensing accounts for 20% or so. Note, however, the margins in the phone hardware business, which were never great to begin with, but have fallen steeply the last two quarters and are now negative. Remember, too, that these are gross margins, so operating margins in this business are likely substantially lower still. Computer and gaming hardware (Xbox, Surface, and a few other things) is becoming increasingly profitable at a gross margin level, however, helping to justify the continued investment in two products many people consider non-core to Microsoft’s business.

Consumer Office 365 revenue growth is slowing

For the last several quarters, Microsoft’s additions of consumer Office 365 subscribers have been pretty strong:Consumer Office 365 subsHowever, the worrying thing is that the revenue from these subscribers seems to be stagnating. This isn’t a number Microsoft reports directly, but it does provide enough data points to allow us to estimate it with reasonable accuracy, and the trend isn’t good:Consumer Office 365 revenuesWhat’s interesting is that the lines in these two charts track quite closely in their shape for the fist five or six quarters, but they then begin to diverge. So what changed? Well, two main things, I think: Microsoft introduced the Personal (single user) version of Office 365, at $70 versus $100 per year for the multi-device standard version; and secondly, Microsoft has been doing lots of free trials and other deals which either heavily discount or entirely remove the fees for some subscribers for a certain period (often as much as a year). I suspect that both have had an impact, but the rate at which growth has dropped off suggests that the free trials in particular are eating into growth substantially. What I’d really like to see from Microsoft is a paid subscriber number (much as Netflix reports in its financials), which would give a much truer picture of both real subscribers and revenue per paid subscriber. The big problem here, of course, is that Office 365 consumer revenues need to grow to offset the rapid decline in legacy Office sales to consumers, but with no growth, the overall consumer Office revenue line is now declining rapidly too – it dropped 17% in FY 2015. Some of this is because of the way revenue is recognized on Office 365, but that’s certainly not the entire impact, as revenue per subscriber appears to have dropped from around $100 per year to closer to $50 over the past year or so.

Surface, Lumia and other phone sales

Lastly, I just wanted to cover quickly sales of Microsoft’s three main first-party hardware categories – Surface, Lumia phones, and non-Lumia phones. The first two are actually going fairly well, posting year on year increases in sales several quarters running:Surface revenuesLumia unit salesHowever, non-Lumia phone sales (feature phones) have fallen off a cliff these last few quarters, and as I wrote previously, I suspect the impairment and restructuring of the phone business was at least as much about this business as the smartphone side:Non-Lumia phonesI continue to believe that the launch of Windows 10 on phones, and the flagship(s) Microsoft will launch later this year, will be the last big test for Windows on phones, and whether Microsoft can indeed make a go of this business.