Diversification Continues at Big Tech Companies

on August 4, 2016

Employee diversity numbers were in the news this week as Apple announced new figures which suggested progress in hiring more underrepresented minorities and in closing the pay gap between men and women. But throughout this earnings season, diversification of a different kind has been in evidence – the diversification of business models and revenue sources by all the big tech companies. This is an interesting counterpoint to something I wrote about here some time ago — the reliance by all the big companies on a successful, high-margin core business. In that piece, I also suggested these core businesses help fund ventures in many other areas, some of which eventually become highly successful in their own right. Those non-core businesses were a definite theme throughout the earnings reported over the last couple of weeks.

Diversification benefits these companies in several ways. First, it provides a useful hedge against underperformance in the core business, since non-core activities often have different drivers and headwinds than the core. Second, it allows companies to leverage their strengths into new areas, giving them a leg up against competitors who may be starting from scratch. Third, it sometimes produces products or services which can eventually be integrated back into the core business, strengthening it. Here are some of the ways in which the biggest tech companies are diversifying today.

Alphabet – Other Bets

Alphabet is perhaps the one company that has explicitly separated out its non-core business into its own reporting segment – Other Bets, which encompasses everything that’s not part of Google, including self-driving cars, Nest, its venture arm, Verily, and so on. The creation of Alphabet and the new reporting structure shines an unusually bright light on these non-core activities and the results look ugly at first sight. Though margins have improved somewhat, we’re still talking about negative 400% operating margins for the Other Bets as a whole and a significant overall loss despite revenues less than 1% of Alphabet’s total haul. But this is what investing in non-core businesses often looks like – the vast majority of what Alphabet does in Other Bets is, as the company likes to say, “pre-revenue” and that shows. Its separation in financials also allows the core Google business to shine even more, freed from the financial drag of the moonshots. Within the Google segment, the company is also investing heavily in enterprise services, including both Apps and its cloud services, which it hopes will grow to be a significant business in its own right. There’s less transparency about that venture, but it’s arguably just an “Other Bet” that’s a few years further down the road.

Amazon – AWS, but also services in general

The headlines with Amazon recently have mostly been about AWS, its cloud business and that makes perfect sense. It’s growing rapidly and also increasingly profitable, as well as being much more profitable than the rest of Amazon. As such, it’s making a more important contribution to Amazon’s overall results. But it’s still just 10% of Amazon’s overall revenues. The bigger picture here is Services in general, which made up 31% of Amazon’s revenues in Q2 and 28% over the past twelve months. The bigger Services segment at Amazon includes its third-party fulfillment services, Prime subscriptions, advertising, and credit cards. Third-party fulfillment is a particularly important area for Amazon, because it is characterized by far higher gross margins than Amazon’s first-party e-commerce sales and is another driver of Amazon’s recent improvements in margins. Seller units made up 49% of total units sold in Q2, up from 40% two years ago and 30% six years ago. This percentage has been rising in an almost linear fashion recently and is a form of diversification more subtle than some of the others we’ll look at today, though no less important. Prime subscription revenue is also an increasingly important source of revenue for Amazon, though one tied directly to e-commerce sales as part of Amazon’s famous flywheel.

Apple – Services again

Whereas the Services line has been quietly growing at Amazon without much fanfare, Apple has been making plenty of noise recently about its own diversification into Services and that was the case again this quarter. CFO Luca Maestri pointed out on the most recent earnings call that Services grew from 8% of revenues a year ago to 11% this past quarter, partly through stronger Services sales, but partly also helped by falling hardware revenues driven by the iPhone drop. But perhaps the more significant comment was that Services was an even greater contributor to profits than to revenue. That’s a stark contrast to the conventional wisdom of just a few years ago when this part of the business (then largely about iTunes) was seen as a break-even one. That’s clearly changed and, like AWS, Apple’s Services business is the rare non-core business that has better financial characteristics than the core it complements. Then there’s Apple’s massive spending on R&D, much of which Tim Cook said on this quarter’s earnings call is going to products and services that aren’t yet in the market. That certainly includes its investment in car research, but likely also includes other forms of diversification we haven’t yet seen concrete evidence of.

Facebook – Oculus and WhatsApp

Facebook has arguably been diversifying away from its core Facebook experience for some time in both organic and inorganic ways. The Instagram acquisition was the first big outside addition to its portfolio and the first major non-Facebook branded product it owned. But what characterizes both its WhatsApp and Oculus acquisitions is the fact that – like Alphabet’s Other Bets – they’re largely pre-revenue. Yes, Oculus is now shipping some units, but as Facebook itself has conceded, the revenue from those shipments isn’t likely to be material anytime soon. WhatsApp has effectively closed down its one revenue stream as it builds massive scale, so it fits into this category too. You only need to look at Facebook’s ballooning R&D spending to see the financial impact of all this, but as with Alphabet, these bets on the future seem to be covered just fine by a blossoming core business. Facebook itself, coupled with the increasingly important Instagram, seem to be delivering fantastic growth in both revenues and profits, providing plenty of cover for investment elsewhere.

Microsoft – Hardware and Services

For all that Steve Ballmer’s famous “Devices and Services” mantra has been thoroughly scrubbed from Microsoft’s strategy statements, it’s very much in evidence in its financial reporting. In the fiscal year just ended, Microsoft generated 5% of its revenue from Surface alone, with another 4% from Phone and 11% from Xbox hardware, software, and services, for 20% of its total revenue from these hardware categories. A variety of services business models are taking over traditional one-off software sales categories, with cloud services of various kinds perhaps the best example, whether that’s Office 365, Azure, or other elements of the portfolio. Commercial cloud services were 11% of revenues at Microsoft in the past year, up from 6% a year earlier and 3% the year before that. But perhaps the most surprising contributor to growth at Microsoft recently is search advertising, with advertising revenue being the fastest-growing category of revenue from external customers and making up 7% of total revenue.

Different focuses, different results

Though the benefits of diversification are often the same, the specifics are just as often very different. Each of these companies is focusing in somewhat different areas when it comes to diversification and the results are very different too. Some are very long-term focused and are reaping massive losses in the short term while they attempt to build businesses that will pay off later. Others are already generating very meaningful revenues and profits from some of their new ventures today. Yet other companies I haven’t listed here don’t seem to be investing in a big way in this diversification, In some cases, it’s because they’re still struggling to optimize their core businesses – Twitter probably belongs in this category. But diversification will continue to be a feature of the best technology companies long into the future.