Apple, Apple Watch, Earnings, Q2 2015

Apple Watch sales

So, after yesterday’s preview post on Apple Watch sales, I thought I’d have a stab at interpreting today’s earnings report and call on this specific point. Yesterday’s post highlighted the challenges and pitfalls inherent in such an exercise, so I’ll walk you through all my assumptions so you can follow along and decide whether or not you agree on the way.

Other Products revenue

As I said yesterday, the starting point for this analysis is revenue from “Other Products”, the Apple segment which includes all hardware products but the big three, along with both Apple’s own and third party accessories. That category has been in decline, but not a very consistent rate of decline. Revenues this quarter were $2.641 billion in this segment, compared to $1.767 billion a year ago (on the restated basis Apple provided in January, which includes Beats headphones). That means growth of $874 year on year, and $952 sequentially. I always find annual growth a more useful measure, so we’ll focus on that. I’m going to assume that Other Products revenue excluding Apple Watch declined by 10%, to around $1.6 billion.

This is based on the recent rate of decline, and you could argue that we might put this number as low as $1.4 billion, but I’m not necessarily ready to go quite that low. Cook confirmed on the earnings call that both iPod and accessories shrank year on year, but didn’t say how much. If we take $1.6 billion as our number, that gives us just over $1 billion in revenue for Apple Watch, which is obviously a lot lower than I talked about yesterday.

Average selling prices and unit sales

The next challenge is to set an average selling price (ASP) to divide this revenue figure by to get a unit shipment number. My assumption for average selling price had been that it was likely somewhere around $500, which is a nice sort of midpoint between the lowest and highest prices for the two mainstream models, the Watch Sport and Watch, implying that the two had sold in roughly equal proportions, and/or that Edition sales helped push ASP up a little if Sport sales outweighed Watch sales.

However, there are a couple of things that suggest we should moderate this: one is some survey data that suggests a heavy skew towards Watch Sport sales, and therefore a lower ASP. But the stronger signal came today from Apple itself. On the earnings call and in conversations with various reporters, Apple’s executives have suggested that sell-through for the first nine weeks for Apple Watch were ahead of the same period for the iPad. That’s a very specific thing to say, and deliberately doesn’t give us a specific number to work with either, since the iPad was on sale for 12 weeks when its first quarter of sales was reported. So we don’t have a 9-week number for iPads. The first reported quarter number was 3.27m iPads shipped (not necessarily sold through), so perhaps we apply a 75% figure to that, which assumes a somewhat straight-line trajectory, which may or may not be realistic. 75% of 3.27m is 2.45m. If we want, we can also make an adjustment for the fact that this is shipments, not sell-through, and perhaps reduce it a tad more. But on this basis Apple might have sold 2.5 million Apple Watches by the end of the quarter.

So let’s take that number and figure out what it implies about average selling prices. $1 billion in revenue divided by 2.5m shipments suggests an ASP of exactly $400, which is quite a bit lower than my original $500 figure. But if sales did indeed skew heavily towards the Watch Sport, and if most buyers didn’t buy extra straps and so on, it’s just about realistic.

Moving to a range

That gives us a very specific set of numbers:

  • $1 billion in revenue
  • 2.5 million shipments
  • $400 ASP.

But that’s a lot of false precision, because it’s based on all kinds of assumptions. The revenue might have been as high as $1.2 billion, for example. ASPs might have been higher – perhaps as much as $450. Applying these numbers gives us more of a range:

  • $1-1.2 billion in revenue
  • 2-3 million shipments
  • $400-450 ASP.

That seems like a reasonable set of numbers to me, and I’m pretty happy with those. I’m curious to see what numbers others come up with.

Looking forward

I ended yesterday’s piece with a bit on looking forward, and I feel really comfortable with the qualitative side of that, even if less comfortable with the quantitative side. Apple execs on the call today certainly hit many of the points I mentioned in that section. But one thing that I found interesting on today’s call was that sales are still ramping at this point, from April to May to June, contrary to my assumption that things might slow down a little in Q3 and then pick up again in Q4. I’m very curious to see how this actually plays out now that the Apple Watch is on sale in all but one of the countries where Apple has stores, and certainly all of its major markets.

Apple, Apple Watch, Earnings, Q2 2015

Evaluating Apple Watch sales

There’s going to be tons of noise this week about Apple’s earnings, with a particular focus on the sales of the Apple Watch. However, there are two key problems with all of this, and they are:

  • Apple almost certainly won’t give us the number of Watches sold, and estimating that number requires making a series of assumptions, which taken together make the resulting number pretty imprecise
  • Whatever the number various people come up with, we’ll be deluged with articles saying that the Watch has somehow flopped, that sales have fallen short of expectations, and so on, because it’s enormously difficult to know how to evaluate the number.

The rest of this post fleshes out these two points, with a view to providing some context for tomorrow’s earnings call.

The difficulty of estimating Apple Watch sales

As a quick reminder (for a longer primer, listen to this week’s episode of the Beyond Devices podcast), Apple Watch revenues will be reported under the “Other Products” segment, one of Apple’s five product segments, as of earlier this year. And in that Other Products category, you’ll also find revenues from the iPod (until recently broken out separately), third-party accessories, Apple’s own accessories (including Beats headphones), and Apple TV. Last quarter, that was a $1.7 billion revenue bucket, which was down about 10% year on year, but the rate of growth or decline has been fairly unpredictable. So the first thing you have to do if you want to calculate Apple Watch revenues is to make a set of assumptions about the rest of this segment and what results would have looked like without the Apple Watch. Perhaps you decide that revenues would have been around $1.6 billion based on that same 10% year on year decline, though in reality the range is likely anywhere from $1.4 billion to $2 billion based on the trends from the past two years. That, by itself, gives you around 1 million units’ worth of softness in your estimate between the two extremes.

At that point, you have your Apple Watch revenue number, and you’re ready to move on to the next step, which is figuring out how that revenue number translates to unit shipments. The challenge here, of course, is that this is easily the widest price spread of any Apple product: from $349 all the way up to $17,000 (and that’s just the US dollar pricing).  The assumptions you make about the mix between the various models are going to make a huge difference to the unit shipment number you come up with. In the grand scheme of things, Edition sales are likely to be tiny, but at that price point (around 20 times that of the midpoint of the other models), small differences in your assumptions will make big differences in your outputs. For the sake of illustration, I’ve presented in the table below three possible scenarios, which all give roughly the same total revenue figure of around $4 billion for the quarter:

Three Apple Watch scenarios correctedHowever, what you’ll see is that, depending on how you flex the mix between the three models, you’ll get a very different number of shipments – under these three scenarios, anything from 3.15 million to 7.8 million. And one of the biggest variables is the number of Edition sales you assume, as you can see from the third column. However, as the third scenario shows, if you shift the mix between the other two models radically, you get a similarly significant effect. So much depends on your assumptions. For what it’s worth, none of the three scenarios above represents the mix I’m expecting to see – they’re purely illustrative. I would think we might see around 5 million sales, at around $3-4 billion in revenue, but along with everyone else, I’m guessing now, and I’ll be guessing to an only slightly smaller extent after the results are out.

(Note: an early version of this post had an error in the spreadsheet above, which has now been corrected – the core point remains unchanged).

What constitutes success?

Now that we’ve established the pitfalls associated with estimating actual numbers, we move on to the other big question: how we should evaluate those numbers. This also goes to the heart of the question of why Apple likely won’t give us any numbers, which comes down to two things:

  • Early in a product cycle, the actual numbers are as much a function of supply as of demand, and so they don’t reflect actual demand accurately
  • Apple has barely started to sell the Watch, there are significant updates coming later in the year, and the word-of-mouth marketing which I still expect to be a big component of how sales grow has barely got off the ground, because there simply aren’t that many Watches out there.

You could make a strong argument that, whatever the actual numbers are, the Watch launch has already been a huge success, for two reasons: firstly, demand continues to outstrip supply, which (assuming supply isn’t being artificially constrained to create the illusion of shortages) is always a good sign; secondly, Apple is now catching up to demand across 18 SKUs and many variants behind those, which is logistically an enormous achievement by itself. With previous major product launches, there was essentially one SKU – one iPod, one iPhone – or slight variations by storage capacity. One of the biggest challenges from a supply chain and logistics perspective for the Watch has been the sheer variety of the individual models and the difficulty of predicting which would be most popular.

Another way to look at sales is in the context of past Apple product launches and there, too, the Apple Watch likely comes out ahead. The iPod sold 125,000 in its first quarter, the iPhone sold 270,000, and the iPad sold 3.3 million. Watch sales might be close to the iPad launch, but I suspect they’ll be higher. However, unlike the iPad, which was a standalone device from the beginning, the Watch is a companion device to the iPhone, so its addressable market is arguably narrower. Compare Apple Watch sales to the sales of any other smart watch or even fitness device, though, and they again come out on top. Fitbit sold 3.9 million devices of all kinds in Q1, so Apple Watch might again be close to that this quarter, but probably slightly above it, and Fitbit is by far the market leader in this category, with smartwatches a much smaller category (and a small subset of Fitbit’s device sales).

What next?

Is there any sense in which the Apple Watch can be considered not to have been a success, assuming the numbers come in roughly where I think they will? I think so, but it’s mostly a matter of timing. What I mean by that is that I suspect the Apple Watch will quickly get to the point where it’s Apple’s second-highest selling product, behind the iPhone but ahead of the iPad, probably either in Q4 this year or sometime next year. But for now, it’s quite a bit smaller than Apple’s other products. It doesn’t seem to be hitting the same mainstream consciousness as other recent Apple devices as quickly.

I regularly meet people for whom my Apple Watch is the first one they’ve seen in the wild, as it were. And I continue to believe that word of mouth marketing is the most effective form of marketing for the Apple Watch, as a new product in the market, and as a product that’s distinct even from other entrants in the category. My wife and I both have Watches, and when people spot them, they often ask, “How is it?” or “Do you like it?” And we both respond, “It’s great” or words to that effect, but I continue to struggle to articulate the reason why they’d be great for everyone, or even for most people. My Watch is enormously useful to me because of the notifications especially, though I also enjoy the at-a-glance information on the screen at all times, and the fitness tracking is a nice bonus.

I suspect that what will really start to change this is the emergence of a really strong set of third party apps, and that will have to wait for WatchOS 2 in a few months’ time. Apps were critical to the success of the iPhone and iPad, and I think they’ll be even more critical to the success of the Watch, and I’ve said this from the start. It’s only when you get innovation happening among third party developers about what’s really possible when you have a wrist-worn, always-present supercomputer that you’ll really start to see the potential in this category. And allowing those developers to run their apps on the Watch itself, and to make use of both the hardware and software features that Apple’s own apps already have access to will be a huge step forward.

As such, I’m expecting that Q3 may be a quieter quarter for the Watch, in which Apple may well sell fewer devices than in Q2, but Q4 will be absolutely huge, both because of the impact of WatchOS and native apps, but also because of holiday buying, at a time when many more people will know someone who has a Watch and loves it.

Berkshire Hathaway, Big picture, Google, Management

Google isn’t Berkshire Hathaway

Update: given Google’s Alphabet announcement on August 10th, I’ve written a new post which refers back to this one. You might like to read that one too.

That’s likely an odd title, but both the title and this post were prompted by a paragraph in a Wall Street Journal article about Google ahead of its earnings later this week. The paragraph, which references remarks made by CEO Larry Page at a meeting with large shareholders back in December, reads as follows:

Mr. Page said he looks to Berkshire Hathaway Inc., the insurance-focused conglomerate run by billionaire Warren Buffett, as a model for how to run a large, complex company, according to people who were at the meeting. Mr. Buffett has a cadre of CEOs running operating companies and doles out capital from the holding company to these businesses based on their performance each year.

I first saw references to this paragraph on Twitter, and subsequently decided to read the whole thing. While the tenor of the article overall is very much in keeping with my own views on Google (it seems to be facing increasing headwinds and is doing a poor job of explaining how it will weather them), this idea attributed to Page struck me as particularly odd, and somewhat worrying. And the simple reason is that, even though it’s perfectly normal (and sensible) for CEOs to seek to learn from other CEOs how to run their companies, Google is nothing like Berkshire Hathaway, and indeed it shouldn’t be. Below, I’ll outline several reasons why I find Page’s remarks concerning.

Berkshire Hathaway is a conglomerate

I don’t know any more about Berkshire Hathaway than the next person – it’s simply not a company I’ve spent a huge amount studying. But I have learned enough previously (and researched enough today) to provide a brief primer. First off, Berkshire Hathaway is, famously, a conglomerate. That means, in part, that one of its defining features is that it’s a very diverse business with many unconnected parts. Wikipedia’s definition is likely as good as any (emphasis mine):

A conglomerate is a combination of two or more corporations engaged in entirely different businesses that fall under one corporate group, usually involving a parent company and many subsidiaries.

Berkshire Hathaway itself wonderfully fits this description. Though the Journal article describes it as “insurance-focused”, in reality BH’s assets are incredibly diverse, including Dairy Queen (a restaurant chain), Fruit of the Loom (clothing), a railway, energy companies, half of Heinz, a whole range of others and, yes, a sizable insurance business. Many of these businesses are indeed run entirely at arm’s length, and they can be because they have no connection with each other. They can also be run in this way because they’re all profitable in their own right (at least at a divisional level), and so don’t need the other subsidiaries to prop them up. The only real connections between BH’s various businesses are the 25-strong headquarters staff and the fact that the company uses the “float” (the premiums received but not yet paid out on) from the insurance business as a cheap source of investment money for the other businesses.

Google is not a conglomerate

On, then, to Google, which I know and understand much better and which is very different from Berkshire Hathaway. There are several key points here:

  • Firstly, Google isn’t a conglomerate – its businesses have hitherto had fairly strong connections with each other, and in some cases a very strong connection. At a basic level, almost all of Google’s businesses (until relatively recently) have been Internet services businesses, and even all its current businesses are at least technology businesses. That, alone, makes them far less diverse than most conglomerates, and than the the definition above suggests.
  • Secondly, although Google has many products and services, it doesn’t have “many subsidiaries” – these products and services have largely been interconnected, as I just described, and as such can’t simply be treated as a series of subsidiaries to be managed separately, as Berkshire Hathaway’s various assets can.
  • Thirdly, the pieces of Google aren’t and can’t be independent in the way BH’s various businesses are, because many of them (including some of the largest, such as Android and YouTube) simply aren’t profitable in their own rights. Though the management of some of these bigger parts can be given a measure of autonomy, they can’t run anything like BH’s various subsidiaries can because they rely on the other parts of Google to stay afloat.

I’m not sure which explanation for this disconnect worries me more – either Larry Page doesn’t understand these important differences between Google and Berkshire Hathaway, or he’s planning to turn Google into a true conglomerate along the lines of BH. Neither seems like a good sign. I’ve already talked about the first of these, so let’s tackle the second. Though some of Google’s recent acquisitions haven’t fit with certain popular visions of what Google is as a company, I believe they all fit if you look at the company through the right lens: as a machine learning and artificial intelligence company (something I wrote about in detail in this piece). I think there are still concerns about Google, as I said at the outset, but I don’t think over-diversification is one of the biggest.

However, if Page really is planning to build a conglomerate, that’s even worse news. For one thing, he’s absolutely the wrong guy to run it if he’s using Warren Buffett’s model as his ideal. Warren Buffett is, above all, a very shrewd investor, and Page’s major acquisitions have been anything but shrewd from a financial perspective. But using Google as a vehicle for further investments also doesn’t seem like a good idea, regardless of who’s running it. Conglomerates are notorious for diminishing rather than enhancing the value of their subsidiaries, and Berkshire is the exception rather than the rule (and Buffett has articulated clear reasons why).

The one way in which Google could be like Berkshire Hathaway

There is one small way in which Google might be like Berkshire Hathaway, and that’s the fact that Google, like BH, has one part of its business that generates significant sums of money that can be used to invest in the rest. At BH, this is the float – not technically profit, but still cash on hand that can be invested elsewhere. At Google, it’s the search advertising business that is Google’s profitable core. However, unlike BH’s insurance float, which seems fairly safe for the time being and has been steadily growing over the years, Google’s core business seems increasingly threatened, and it’s not clear that any of its other businesses are in a position to supplement or supplant it as a major source of revenue in the near future. The key difference, then, remains that BH uses its float to invest heavily in businesses that are already successful, whereas Google invests its profits into businesses that need the money just to run, because they’re unprofitable.

I think the most charitable reading of Page’s remarks is that he only sees Buffett’s model as a guide at a very superficial level – of giving his various direct reports a certain amount of autonomy. I certainly hope that’s what he meant by the comparison, because almost any other reading of them is worrying, to say the least.

Earnings, Microsoft, Smartphones, Windows, Windows 10, Windows Phone

Microsoft’s devices restructuring

Microsoft today announced a restructuring of its devices business which I think most of us have been expecting to land any day since CEO Satya Nadella’s memo to employees a couple of weeks ago indicating tough choices were ahead (and indeed, which the company strongly hinted might be coming back in April). However, even though this was widely anticipated, the exact meaning of it is less obvious. I see many taking it as a capitulation, but Microsoft clearly isn’t getting out of the phone business at this point. Below are my thoughts on what this move means, and what might still come later.

Not a concession of defeat – yet

Though clearly a concession that things haven’t been going well for its devices business, this isn’t a concession of total defeat just yet, and there are two reasons why I say that:

  • Microsoft accounts for almost all Windows Phone device sales itself, with over 95% of the market according to AdDuplex. As such, killing its own devices business would simultaneously kill Windows Phone as a platform
  • Microsoft’s positioning around Windows 10 has had a heavy mobile component, with universal apps and various tools for porting apps from other mobile platforms major focus areas in the announcements over the last several months.  As such, it seems extremely unlikely that Microsoft would be ready to kill off Windows Phone.

In short, the timing just doesn’t seem right for abandoning either Microsoft’s first party phone business or Windows Phone as a whole. That’s not what’s happening today, though that doesn’t mean it’s not coming somewhere down the line, as I discuss below.

Windows 10 and focus

It’s clear that at least some within the business believe that Windows 10 and some of the related efforts targeted at developers will help to turn the fortunes of Windows Phone around. I’ve shared my skepticism about that hope in several pieces here over the last few months (including the two linked to in that second bullet above), and wrote an in-depth report about Windows Phone and its prospects too (available here). I continue to believe that Windows Phone suffers from several more or less insurmountable challenges, and don’t see any clear way out of this situation even with Windows 10.

At least part of the problem with Windows Phone has been that it was losing money at its current scale and that scale wasn’t growing rapidly enough to make a difference. By scaling down the business still further, Microsoft likely shifts the equation slightly in favor of profitability, though at the rate the feature phone business has been declining, that may not be enough. But the focus Microsoft is planning to bring to its portfolio is a good thing – for such a small devices business, Microsoft (and Nokia before it) has had a bewildering array of devices on sale, and could likely get by with a much smaller number, say one or two in each of its series (500, 600, 700 etc). But amid this “focus” comes this statement reported by Mary-Jo Foley at ZDNet:

Microsoft will focus its phone efforts on three segments: Businesses, value-phone buyers and flagship phone customers, moving forward.

This is a funny kind of focus! As far as the smartphone market is concerned, flagship and value phones are basically all there is at this point in many markets, so that’s no focus at all. And the mention of business users reflects a basic misunderstanding of the phone market which Nokia seemed to have overcome way back, when it abandoned its E-Series devices. The fact is that business users are just the same as anyone else – they want phones they like to use, that allow them to do not just work but personal stuff too. I’m also curious what this all means about the feature phone business and whether Microsoft will now abandon that entirely. There was a theory that being in feature phones would allow Microsoft to provide a migration path to smartphones over time, but I’ve always been skeptical about that, and at the rate of decline this business is seeing, it’s more of a liability than an asset at this point.

Microsoft shrugged

Meanwhile, the impairment charge is so large that it’s hard to imagine that it’s for anything other than the whole value of the business acquired from Nokia. Remember that though the total price paid to Nokia was 5.44 billion euros (reported as $7.2 billion at the time it was announced), only 3.79 billion (or $5 billion) was for the devices business, while the other $2 billion or so was for patents. The $7.6 billion impairment charge is therefore not just more than the original purchase price, but significantly more than the price paid for the devices business specifically. That either means that Microsoft is also writing down some of the value of the patents or accounting for a significant additional investment in the business since the acquisition (or both). However, at the end of the day, the key point is that Microsoft has at this point basically unburdened itself of the value of the acquisition, such that if it does have to wind the business down it likely won’t have to take another significant impairment charge.

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.

As such, if Microsoft does have to abandon Windows Phone and its own devices business (I simply don’t see how it’s going to get more OEMs on board for Windows Phone, so the two are inextricably linked), at least it’s now written down much of the value of the acquisition, and will have eliminated most of the employees by the end of this year. That will make it much easier financially and operationally (if not emotionally) to pull the plug when the time comes. But it will be a huge sea change for Microsoft to concede defeat in operating systems for mobile devices after 15 years of trying.

Postponing the inevitable

I suspect today’s move is just another step along the road that eventually leads to an abandonment of this business, even if Microsoft isn’t ready to concede defeat today. The good news is that Microsoft has a strong alternative strategy in place with its third party mobile apps business, which has produced some good results recently, so that it’s not putting all its mobile eggs in the Windows Phone basket as in the past. I continue to worry that a third-party apps business may struggle as both Apple and Google increasingly tie their first party services tightly into their operating systems and virtual assistants, but it certainly seems to have a better shot at gaining users than Windows Phone for now.

However, the other big challenge is monetizing that usage, which continues to be my biggest concern for Microsoft. Its traditional software licensing model simply isn’t going to cut it in consumer markets, and I suspect the SaaS model will be equally challenging. As such, as I outlined in my “Thesis on Microsoft” piece a while back, Microsoft is going to have to make its money more or less exclusively through enterprise cloud services while using the consumer market to drive continued scale.

Broadband, Google, Google Fiber, TV

Google Fiber’s real innovation

1 Comment

I’ve written about Google Fiber just once before, and that was to talk about my installation experience when I briefly lived in one of the very few areas where the service is available, in Provo, Utah. However, today I wanted to unpack something different about Google Fiber, in part in response to some recent articles I’ve seen, such as this one. These pieces often cite competition from Google as the major factor in a perceived shift in the status of broadband in the US, and that isn’t quite what’s happening. I would argue that Google has had a significant impact on the rollout of broadband in the US, but mostly not because of direct competition.

Maps tell part of the story

As I mentioned in that opening paragraph, Google Fiber is actually available in very few places today. Here’s the map from Google’s Expansion Plans page:Google Fiber map

 

The company being most aggressive currently with rolling out gigabit services is AT&T, and here’s its equivalent map:

Screenshot 2015-07-06 10.33.41

 

Note, first of all, that both companies have the same three categories – cities where they offer service today, cities where they will definitely launch in future, and cities which are in an exploratory stage. That’s something that we’ll come back to later.

But the second thing to note is that, of the 27 metro areas listed in total on the two maps, just seven appear on both maps, with the other 20 being mutually exclusive. Yes, you can absolutely make the argument that AT&T is responding to competition from Google in some of these markets, notably Austin (the same goes for some of the incumbent cable operators). But in a majority of cases, AT&T is launching or contemplating a launch in cities where Google isn’t present. So, though Google helps to explain why AT&T is launching gigabit service in some markets, it’s clearly not the whole answer.

Google’s real innovation: turning the model on its head

In what sense, then, is Google having a significant impact on the market? Well, the answer is that the key innovation Google brought to the broadband market has nothing to with technology and everything to do with business models. Essentially, it turned the traditional model on its head. If you’re not familiar with how broadband and TV operators usually roll out service, here’s how it’s traditionally worked. The provider approaches the municipality where it wants to offer service, and requests permission to do so. The municipality then extracts every possible concession from the potential provider before finally (if the provider accedes to the terms) granting permission. These concessions have typically included minimum coverage requirements, free access for schools, libraries and the like, carriage of local content on TV services, and so on. Essentially, providers have traditionally had to bribe municipalities with a variety of goodies just to get permission to offer service, and then have often still had to work very hard to get access to infrastructure needed to roll out the service.

Enter Google. Google’s process, of course, was entirely different: it essentially announced a competition for a city to become the first Google Fiber location, and invited cities effectively to bid for the privilege. What happened as a result was that over a thousand cities across the US applied, and Kansas City was eventually chosen. In the process, Google turned the usual model on its head – instead of municipalities extracting concessions from Google to roll out fiber, Google would extract concessions from cities for the privilege of having Google Fiber rolled out. Cities wouldn’t impose any “redlining 1” restrictions, they’d smooth the path for Google to build the necessary infrastructure, and so on.

The first reaction of Verizon and AT&T, which had just spent painful years getting franchises in many individual municipalities for their fiber rollouts, was outrage. However, their second reaction was far more productive, which was to say that they, too, would be willing to roll out such services if cities would offer them the same terms and concessions, starting with Austin, Texas, where AT&T was one of the incumbent operators. Though this claim was met with some initial skepticism, AT&T has since followed through not just in Austin but in a number of other cities where Google isn’t present at all. AT&T, then, has benefited enormously from Google’s business model innovation, which allows for a demand-led rollout facilitated rather than held back by local municipalities. And it’s this innovation which has allowed AT&T to rapidly expand its GigaPower services to many other cities too, well beyond those where Google is competing with AT&T. (Verizon, of course, had largely completed its FiOS rollout by the time these changes happened, and so wasn’t able to take advantage of them in the same way).

Rollout details

As I close, I’ll return briefly to something I asked you to note earlier – the three categories of cities both Google and AT&T list on their maps: open markets, announced markets, and markets under consideration. This is a critical part of this whole model, and the innovation Google brought to the market, because the markets under consideration are those currently being invited by the two companies to make big enough concessions to make a rollout worthwhile. The same process that got Google Fiber into Kansas City is now being repeated across the country by AT&T and Google in very much the same way.

What’s very different between the two companies, though, is the way they treat those first two groups, and Austin is a great case study of this difference. Google announced the Austin market in 2013, and now has one neighborhood (or Fiberhood, to use Google’s terminology) up for sale. Four other neighborhoods are listed as under construction, while “Rest of Austin” (the vast majority of land area in the city) is described as “coming soon”. Contrast this with AT&T, which made a rushed announcement within a week of Google’s, but completed its 1 gigabit rollout by September 2014. AT&T’s big advantage, of course, is that it already has a network and lots of customers in Austin, and in almost all the other cities where it will launch GigaPower service. This obviously dramatically speeds up the rollout, and in almost all cases will mean that AT&T is way out ahead of Google even in cities where the two compete. (In Austin specifically, the fact that AT&T owns a lot of the infrastructure Google needs access to for its rollout has been another significant factor).

Closely connected to this is the size of the cities these two companies are targeting – though Google has tended to focus mostly on second-tier cities in its early rollout, AT&T is already in Chicago, Miami, Atlanta, Dallas, and Houston, and has other major cities like LA, San Francisco, and San Diego on its exploratory list. Again, when you already have a network, contemplating a rollout in a major metropolitan area is much more palatable than if you’re having to start from scratch. So, AT&T’s launched cities see far greater availability more quickly, but its announced cities are also likely actually see gigabit services widely deployed far faster than Google’s.

So, in the end, though Google spearheaded this move to gigabit broadband, it’s quickly ceding the market to others, and especially AT&T, which are piggybacking off its business model innovation and rolling out services much more quickly. In the end, though, perhaps that meets one of Google’s original goals very effectively, and perhaps better than Google’s own rollout could have done. After all, one of the major drivers behind Google’s rollout was improving broadband access across the US.

Notes:

  1. Redlining is the name given to the practice of excluding certain neighborhoods from an infrastructure rollout on the basis of lower incomes, lower propensity to pay, or for other reasons, which has traditionally been banned by municipalities requiring universal access. ↩
Apple, Apple Music, Friction, Studying Apple, User interfaces

Friction is the Problem with Apple Music, not Complexity

Note from Jan Dawson: I’m honored and grateful to announce that Aaron Miller, my co-host on the Beyond Devices Podcast, will be authoring some posts on the Beyond Devices blog going forward as well. This is the first of what I hope will become a series of posts over time. These posts will have a slightly different tone from the rest of the blog, and will be educational in nature, and frequently tied to research concepts – a concession to Aaron’s day job as a business school professor. To reflect that, these posts will be tagged “Studying Apple“. For more about Aaron, check out the About the Authors page.

Walt Mossberg and others seem to love Apple’s new Music service, but Mossberg’s (and others like David Pogue’s) complaint has been that the applications delivering it are too complex. The criticism applies to both Music on iOS and iTunes on the computer. There is a lot going on in Apple Music; there’s no denying it.

Complexity isn’t the problem, though. Friction is. You might call it a semantic difference, but if you do you’re missing out on an essential aspect of everything human beings make. It’s worth understanding the difference between something that’s complex and something that’s frictional.

User Interface Friction

These three points explain something called User Interface Friction (UIF):

  1. Attention is a scarce resource. Mental effort falls under a concept known as executive function. Simplified, executive function describes the many ways we focus our attention on things. We have a limited store of attention. We can only pay attention to a few things at a time. We can also use up our attention, our ability to focus. Time and rest restore it.
  2. Friction is wasted energy (and wasted attention). Although physical friction has its uses, in most situations friction is wasted energy. It’s a great analogy for users’ attention and software. All of your attention spent on an app should help toward your goal. Wasted attention is User Interface Friction. As excellently described in this article from Coding Horror, low UIF is a goal but some UIF is inevitable.
  3. UIF is affected by both users and the interface. Just like physical friction is a measure of how two surfaces interact, UIF is a measure of how users and interfaces interact. And as app interfaces can be metaphorically “smooth” or “bumpy”, users can also be smooth (expert) or bumpy (novice). Expert users can handle bumpier interfaces, because they’ve learned how to use them.

Obviously, software designers should try to minimize UIF as much as possible. Low friction makes an app more useful and more enjoyable, even if it’s something boring like a banking app. Software designers can even measure cognitive load while users interact with the app, and pinpoint where attention is overspent. (Here’s a 2006 article [PDF] describing ways to measure cognitive load for testing website usability. The Sternberg Memory Test is especially easy to use.) The idea is that if users have to overspend attention to accomplish something, then the interface needs improvement.

I’m not a user interface expert, so I can’t go very deep into the principles of good UI design that have developed over the years. (This Quora discussion is a good place to start.) But I know when I’m experiencing friction. A lot of the time it’s from bad design, but not always.

Some apps are necessarily “bumpy” because of how much they do. Final Cut Pro, for example, is a massively complex video editing application. It does things editors could only dream about a few decades ago. Because of this complexity, Final Cut Pro relies on expert users to reduce UIF. (This is part of the reason Final Cut X, a huge interface revamp, was so controversial.) To be sure, Apple shouldn’t waste editors attention, but it has the benefit of editors knowing how Final Cut Pro works.

Any app, no matter how bad, can be learned with time. That means we can become experts in poorly designed interfaces if we just stick with them. Lazy or poor app designers demand more expertise from users than necessary. Users generally abandon an app if the expertise cost is too high for them.

Apple Music and Friction

Generally, Apple users are not computing experts. That’s not an insult. It’s just the reality of having hundreds of millions of users. Apple’s success fundamentally comes from its ability to make low friction interfaces for very useful products.

Like any company, Apple runs into problems when its novice users are presented with complex products. This encounter puts Apple’s design chops to the test. But some things are just too complex to simplify for novices, and Apple requires users to develop some expertise.

There’s a lot of depth and complexity to Apple Music. Consider all that it does:

  1. Integrates a streaming music library with your owned music library.
  2. Helps you purchase music to make it part of your owned library.
  3. Provides extensive music recommendations—through curated playlists and suggested artists—based on your (complex) tastes.
  4. Brings new music to your attention, organized by multiple criteria.
  5. Plays multiple radio stations.
  6. Gives you a way to organize streaming and owned music in playlists.
  7. Allows you to search for music by multiple criteria.
  8. Gives you control over the play order of the music you’re listening to.
  9. Connects artists and fans, giving artists a way to share their work and lives through multiple media.

This list gets dramatically longer in the case of iTunes on the computer, because it includes movies, TV shows, podcasts, iTunes U, audiobooks, iOS apps, even more radio, and ringtones, along with all the different aspects of organizing, using, and purchasing those things. And let’s not forget all the device syncing, with multiple generations of iPods, iPhones, iPads, and even legacy MP3 players.

How do you keep all of that simple? I’m not convinced you can. Siri commands help some, but don’t get you all the way there. In the end, even the venerable Apple can only get the interface to a certain level of smoothness.

That doesn’t mean we should excuse Apple for bad UI design. iTunes 12 was a big change that introduced a lot of friction. (The money quote for our purposes: “But for now, iTunes 12’s most basic operation—finding and playing media—requires a lot more thought than it should” [emphasis added].)

So what has Apple decided to do with its Music apps? It apparently expects us to develop some expertise. Walt Mossberg and everyone else complaining about the friction in Apple Music also seem to love the value it provides. Apple designers, intentionally or not, are banking on our willingness to stick with it and get better at it.

That doesn’t mean we can’t complain about the friction, though. For me, the worst offender is the mysterious ellipsis button. (Who knows what combination of commands it reveals every time I tap on it? It’s like the UI equivalent of a slot machine.) Over time, we can all hope that Apple reduces the friction for its fundamentally complex Music service. In the end, making complex things frictionless is how Apple pays the bills.

Apple, Apple Music, PR

Apple’s evolving PR strategy

This week on the Beyond Devices podcast (embedded below), we talked among other things about Apple’s evolving PR strategy, using the lens of the Apple Music launch as a way to illustrate how things have changed. I thought I’d do a quick write-up of that segment here too.

The old model

Under Steve Jobs and PR chief Katie Cotton (who retired from Apple last year), Apple’s PR strategy focused on two key components: tightly stage-managed events and announcements, and occasional “leaks” to favored publications, almost always off the record and quoted as being from unnamed sources. Executives did very few on the record interviews, and the media generally were given relatively little access to Apple behind the scenes for on the record stories.

The new model

With Steve Jobs’ passing and Katie Cotton’s retirement, we’re now in the Tim Cook / Steve Dowling era (Dowling was finally announced as the permanent head of PR after an interim period with no formal head of the department), and things are starting to change. The company seems looser and more open, with more access to executives, more communication on the record through other publications, and also more openness to new channels like Twitter.

Apple Music launch as the lens

I think Apple Music is a great lens for looking at all this, because it’s a good example of how some of these new approaches are coming into play. The launch is perhaps best thought of in phases (most of them likely planned, one certainly not):

  • WWDC keynote – the formal announcement
  • WWDC interviews – a range of interviews with publications at or right after WWDC
  • Taylor Swift – the blog post from Swift and the rapid response from Apple, which included more interviews
  • Blog posts and tweets from Apple personnel
  • The New York Times profile on Zane Lowe the week before launch
  • Reviews and interviews released the day of the launch
  • Post-launch activities.

WWDC

The WWDC keynote has been done to death elsewhere, so I won’t focus on that – it felt rushed and a bit unpolished, especially at the end, when the topic was Apple Music. But Apple provided access to Eddy Cue and Jimmy Iovine right after the keynote to a half-dozen publications, and these interviews focused on Apple Music, allowing Apple to provide more messaging and positioning around Apple Music and Beats 1 in particular. There were few new details here, except perhaps for some information about sponsorships on Beats 1, but there was a clear set of messages from the execs: Apple Music was about providing a service, not a utility, Beats 1 was about a human-driven experience in contrast to the algorithmic approaches of others, and wouldn’t be driven by market research but by gut feel, and Apple Music wasn’t about stealing subscribers from competitors but about growing paid streaming. Those messages didn’t necessarily come through as strongly in the keynote, but they came through very clearly in these interviews, about half of which were with music rather than tech publications (more on this later).

Taylor Swift

We covered the Taylor Swift incident in last week’s podcast, but the key things here were:

  • Apple responded incredibly quickly – on a Sunday, no less
  • The first official response came via Eddy Cue’s Twitter account, not an Apple press release – the first time Apple has broken news via the medium
  • Eddy Cue also made himself available for several interviews with publications on Sunday and Monday, to explain his / Apple’s reasoning and again provide messaging and positioning around the actions.

This highlights several of the changes we’re seeing in Apple’s PR strategy – rapid response, the use of Twitter as a medium, and the availability of executives for on the record interviews, used to provide more nuanced messaging and positioning around news. All of these are new – recall “antennagate” and the Apple Maps launch and how it took Apple to respond to those issues, for example.

Twitter and blog posts

Those tweets from Eddy Cue, though, haven’t been the only uses of the medium for breaking news about Apple Music. Zane Lowe has used Twitter throughout the buildup to the launch to tease things and break smaller bits of news, including the announcement of his Eminem interview. Pharrell Williams announced the exclusive debut of his song Freedom on Apple Music through Twitter as well.

Perhaps the most surprising thing (though I suspect it wasn’t an intentional thing on behalf of Apple PR) was the blog post written by Apple employee Ian Rogers, which was posted on June 27th, and announced specific times for the release of iOS 8.4 and the launch of Beats 1. Those times were subsequently scrubbed from the post, but  the very fact Rogers felt free to blog about the launch in this way is yet another sign of the increasing openness at Apple.

More broadly, I’ve very much enjoyed the broader use of Twitter by key executives at Apple – not so much for making announcements, but simply for sharing what they’re up to, making themselves visible on this social medium, and in the case of Eddy Cue even responding to some technical questions from other Twitter users this week.

New York Times profile

The New York Times ran a lengthy profile of Beats 1 lead DJ Zane Lowe on January 28th, and it was a good example of the new on the record pieces we’ve seen in recent months, in the same vein as the Stephen Fry and New Yorker profiles on Jony Ive. It was pretty unsanitized, and began with an apparently frustrating experience for Zane Lowe working with the equipment in his new studio (something which was weirdly echoed in the hour of Beats 1 programming before the official launch). But it also broke a lot of details for the first time about the other Beats 1 hosts and DJs, including Pharrell, Drake, Elton John, St Vincent, Josh Homme, Disclosure, and Dr Dre. This use by Apple of a publication like the Times to break this kind of news is again something of a departure – oftentimes these details in the past would have been leaked to such a publication from “sources with knowledge of the situation”, but this is the new, on the record, Apple.

Reviews and interviews around the launch

The last major phase of the Apple Music launch was the launch itself, for which Apple provided devices running previews of Apple Music the day before, and also provided yet more access to executives like Eddy Cue and Jimmy Iovine, and Trent Reznor. The reviews were nothing new (though the last-minute nature suggests a dash to the finish line rather than a new precedent for reviews), but the interviews were, though very much in keeping with the pattern we’ve already seen above. These interviews again hit many of the same points around positioning and messaging, and allowed Apple to put its spin and story around the launch rather than letting others do it for them. Many of the interviews were published in verbatim question-and-answer formats, allowing the executives to speak for themselves.

What next?

Even after the launch, we’ve seen a continuation of some of the same themes – Zane Lowe is still teasing new stuff on Twitter, Billboard did a profile on hip-hop artists and DJ Q-Tip about the show he’ll be doing for Beats 1 (among other things), and there’s a sense that many of the other themes will continue too.

But even beyond the launch of Apple Music, it feels like we’ve seen several elements of Apple’s new PR strategy here which will stick around for the future. The increased use of Twitter, the on-the-record interviews with executives, the communication with non-tech publications (music ones for the Apple Music launch but also fashion and jewelry publications for the Apple Watch), and so on feel like they will likely all be part of Apple’s PR strategy going forward. Tim Cook famously spoke about doubling down on secrecy a while back, so it’s not like Apple is going to suddenly spill the beans about everything as it happens. We’ll still see tightly stage-managed events to announce the big news, but it also feels like Apple is more willing to be open and to truly communicate about what it’s doing, which has to be credited in large part to Tim Cook, who’s made a number of subtle changes at the company since taking over.

Apple, Apple Music, Music

Apple Music first day review

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Since Apple broke its usual rule of giving reviewers plenty of time to review its new products with the Apple Music launch, giving reviewers just a single day to review the service, I thought I’d break my own rule and do a review of my own based on my first day with the service.

Exactly the app I wanted

First off, the new Music app is just the app I’d wanted and hoped that Apple would eventually launch. I’ve always wanted to just be able to combine the music I already have in iTunes with new music I add from subscription services, but that’s always meant two apps in the past. Now it’s a single app, and Apple made this work just the way it should – “My Music” now means the combination of my library and the stuff I’ve added from the subscription service, seamlessly together in one place. I love this aspect of the service, and it immediately puts it head and shoulders above any other service by itself. The app itself is quick, responsive, not too glitchy (with some exceptions in the iPad version, in my experience today), and I found the layout perfectly logical and easy to follow. I’m increasingly convinced that reviewers calling Apple’s recent products and services “complicated” really mean that they’re very feature rich for v1 products, which I don’t see as a bad thing. By the same token, the iPhone is complicated, but I don’t think anyone calls it that.

As a result of all this, we’ll be discontinuing our other music services more or less immediately, once we’ve recreated a small number of playlists of favorite songs in Apple Music, something I largely completed today, which was very straightforward. I opted for the family plan on Apple Music, which means I’m finally headed for my first experience with Family Sharing. I haven’t heard great things about it from others who’ve worked with it, so I’m approaching this with a bit of trepidation, but hoping it works out OK.

Beats 1 is not for me – at least for now

One of the things I’ve been most interested in ahead of time was Beats 1, and exactly how it would work. We finally have a decent sense of the lineup, and today we got our first taste of Zane Lowe and his unique DJing style. I listened to Beats 1 for the first half hour or so, but found the genre-hopping jarring. Within those first 30 minutes, Zane Lowe played a bewildering mix of old and new material, genres as diverse as metal, rap, and pop, and it just reminded me why I’ve largely stopped listening to the radio in a world with digital music. My tastes in music are at the same time eclectic (I like many genres) and narrow (I tend to like just a few artists within each genre), which makes me a tough customer for this kind of thing (more on this later). I just didn’t like 90% of what I heard on Beats 1, and it gave me a headache. It also felt like Apple was working a bit too hard to promote its exclusives (Pharrell, Taylor Swift, AC/DC etc) and the service itself and Zane Lowe wasn’t free enough to be himself, so I hope that changes as the service goes on.

For You and personalized curation is better

I found the For You section and the personalized curation much more effective in my case, though I found my initial experience with the interest selection as frustrating as I had on Beats (which largely supplied the experience). The jiggling circles from which you choose first genres and then specific artists are fun visually but somewhat annoying to use in practice – as you choose items, they tend to crowd out other options that appear, and you end up choosing a variety of things that you kind of like because they’re the best options available, but they then make it harder to choose others. I think the best description for the genre I listen to most frequently is probably “singer-songwriter” but it’s not even in that initial list of genres, and many of my favorite artists never came up. As such, what I’ve told Apple Music I like is a weird mix of my second and third favorites rather than a true list of artists I really like.

Having said that, once I put a bit more work into this effort, selecting more of those artists with several taps of the “more artists” button, the recommendations For You provided started to get better. I’ve found several tracks I quite like that way already. As such, I think I’ll like this more personalized form of curation more enjoyable than the  generic stuff in Beats 1.

 

Absence of desktop iTunes was bizarre

The weirdest thing about the launch was the things that went wrong – the total absence of updated versions of iTunes for hours after iOS 8.4 became available being the most obvious thing. This meant that the social sharing elements didn’t work at all on devices other than iPhones, with lots of broken links and error messages. It was a bizarre omission and I can only think Apple did it to avoid overloading its servers or something. But it took the shine of the service for anyone who doesn’t own an iPhone or wasn’t able to update their software today for whatever reason. The other odd thing was the hour of music and other stuff Beats 1 played before its official debut at 9am ET, which included Zane Lowe testing his mic and chatting with people in his studio, which was an awkward reminder of the stuff in the New York Times piece about how his equipment wasn’t working in the studio when the reporters were there. Everything seemed to be working fine when the show finally started, but it was another element that seemed to lack polish.

Connect looks really promising

One element I know there’s been a lot of skepticism about is Connect, which is reminiscent of Ping for many people. However, I think this is one of the areas of greatest promise, and one of several things that has the potential to set the service apart from competitors. The content there today is fairly limited, though it’s an interesting mix of polished video, candid snapshots and half-finished material, and even tweet-like text content. The content has lots of shares and quite a few comments, many of them welcoming both the service and their favorite artists’ engagement with it, which bodes well. But we need to see a lot more content from a lot more artists on a regular basis for this to work, so that’s something we’ll have to keep an eye on. As a social platform, though, it already looks vastly better than Ping.

A good start with some polish needed

Although I felt that the lack of polish and the glaring absence of the new version of iTunes detracted from the launch, the app itself is fantastic, and I’m totally sold on it. It’ll easily replace my existing options and do it much better than they ever could, and that’s really what this needs to be. Apple should easily win converts from Spotify with the service, but the bigger question remains whether it can make new customers for paid music streaming. After three months of using this service for free, I suspect many users will find it tough to give up, and that’s another major element in what I think will ultimately be a successful launch. Of course, that also means we won’t see any real positive sign of Apple Music in Apple’s financials until it reports earnings in January 2016 (since the first trial users won’t convert until the very end of September or early October). Ironically, what we may well see before then is a sharper drop off in the already falling music sales on iTunes, so the first impact may be negative rather than positive, especially as Apple is now paying out royalties during the free trials.

Apple, Apple Music, Business models, Music, Streaming

Apple Music’s other financial advantage

This is something I’ve though about quite a bit, and even wrote about briefly as part of a much longer piece ahead of the launch of Apple Music, but I feel like no-one is really talking about. But it’s potentially quite significant for the economics of Apple Music, and especially the per-stream payout rate Apple will end up passing on to labels and artists. Note: it’s already clear that Apple will have a higher per-stream payout simply based on the fact that it’s a paid-only service, whereas Spotify and other large services mix paid and free users. But I’m talking about an additional impact on top of that.

Integration of owned music is the key

The big factor here is Apple’s integration of the music you already own and store in iTunes into the Apple Music experience and into a single app. I think that’s huge for usability, and that was the key point in that earlier piece, but I think it could also be quite significant for the economics of the service. Why is that? Well, with almost any other subscription streaming service, you as the user tend to start from scratch in terms of your existing library. Perhaps you hop back and forth between apps when you play the music you own versus the music you’re streaming, but I’d guess many people just stick to a single app and play all their music from there, even the stuff they may have purchased somewhere along the way, because it’s all available in the streaming service and it’s easier to play it there than switch apps. Services like Spotify will pay out to artists regardless of whether the user already owns the track somewhere else (unless the user has imported their owned music). But when the user’s owned music is also available in the app, Apple won’t have to pay out when the user plays that music.

What’s really hard to know here is the balance between owned versus streamed music the average user plays during the course of a typical month. I know my own usage is heavily skewed towards the music I own and am familiar with, along with a few tracks or albums I don’t own and stream instead. Perhaps others are different, but I’d guess almost all users would spend a significant amount of time playing music they already own. With other services, the provider still has to pay out on this music because it all looks the same, but with Apple Music there will be a clear line between the music the subscriber owns and the music he or she is streaming through the service (even if it’s presented together in the context of the app). If the amount that’s played from the library rather than streamed is significant, this could substantially reduce the number of plays for which payments need to be made.

A higher per-stream rate on Apple Music

At this point, it’s worth thinking about how the economics of streaming music work. Although we often see per-stream rates used in discussions of how much artists get paid through these services, the reality is that there are no set per-stream rates. Rather, these services share some proportion of their overall revenue from subscribers and/or advertisers with those labels and artists whose music their subscribers listen to. The total pot is divided up with labels and artists according to a standard formula, and I’ve pasted the graphic Spotify uses to illustrate this formula below:

Spotify-Royalty-Formula

Once you understand that it’s a matter of dividing up the total pot, it becomes very relevant how many songs are streamed and therefore get to share in that pot. If Apple Music has fewer songs streamed through the service (because a significant proportion are played instead from users’ libraries), that in turn could dramatically increase the per-stream payout for those artists whose music is streamed. That will likely disproportionately benefit new artists and music over older artists and albums, which could be particularly good for those discovered through the service.

Of course, over time, this advantage will be mitigated as the balance between owned and streamed music shifts towards streamed music, as people will likely buy far less music (if any) going forward. But as the first Apple Music subscribers get past their trial periods and Apple starts paying out on its long-term formula, this could result in significantly higher payments per stream than other services. Add this to the existing advantage Apple has over competing services because of the paid-only nature of the service. Over time, that could have a really interesting impact on artists’ willingness to continue to work with other services. If, as an artist, you’re getting paid several times more on Apple Music per stream than on Spotify, Rdio, or Deezer, would you eventually consider pulling at least some of your music from those other services?

Note: I’m making a fundamental assumption here, which is that Apple will only pay out on plays of music the user doesn’t play from his or her own library. That seems a reasonable assumption, but I haven’t confirmed it. I can’t see why Apple would pay out on that music (unless it’s played through iTunes Match, which shares 70% with artists too), but it’s a remote possibility that it will, in which case the argument falls apart. 

Advertising, AOL, Google, Microsoft, Quick Thoughts

Quick thoughts: Microsoft’s ad business

Given today’s news about Microsoft selling its display ad business to AOL and in turn replacing Google as the search advertising provider for AOL, I thought I’d quickly revisit some of my earlier analysis on Microsoft’s ad business.

By way of background, Microsoft has never directly reported the financials for its advertising business, but it has provided enough detail in its past financial reporting that I’ve been able to build a pretty good picture of this business over time. This past quarter, perhaps as a precursor to today’s announcement, Microsoft stopped providing any sort of information about its display ad business, but here’s a quick view of my estimates of Microsoft’s two major ad revenue streams over the past couple of years:

Screenshot 2015-06-29 16.02.44As you can see, Search advertising has been growing very well indeed, almost reaching the $1 billion per quarter mark last quarter, and likely to hit it very shortly, especially with the help of the AOL deal. By contrast, though, Display advertising has been heading south for some time now, and was under a quarter of a billion in revenue for each of the last two quarters of 2014. The split between the two, then, is roughly as shown in the chart below:Screenshot 2015-06-29 16.04.58In other words, search advertising was not only vastly outperforming display advertising in growth terms, but as a percentage of Microsoft’s overall online advertising business. As such, it’s made sense for some time for Microsoft to jettison this part of the business in favor of focusing on the part that’s working: search advertising. Part of the reason for the disparity between the two is general industry dynamics – display has been struggling for other companies too, while search continues to be one of the most effective forms of advertising and to command commensurate rates.  Microsoft’s display ad business, though, was also sub-scale, and hadn’t made the transition to mobile devices and native advertising effectively. Search, meanwhile, has benefited both from positive industry trends and the growth of Bing and Yahoo’s growth in search market share in the last couple of years.

The impact on Google

AOL’s decision to switch from Google to Microsoft is not enormously impactful on Google by itself, but in the context of Firefox’s earlier switch to Yahoo as its default search engine in the US, and the potential for a much more significant switch away from Google by Apple sometime this year, it’s part of a drumbeat of bad news for Google. One of Google’s challenges at this point is that it’s come to compete with many of its erstwhile partners, with Apple as perhaps the most striking example, and it’s arguably starting to pay the price for that strategy.