Profitable Cores and Reinvention

on October 30, 2014

It’s earnings season and, as usual, I’m spending quite a bit of time poring over financial results from major tech companies (some of which I’ve written up on my personal blog here). However, there’s a topic which I’ve been meaning to write about for some time and which the current earnings season presents an opportunity to finally discuss — the importance of a highly profitable core to a tech company.

Profitable cores enable other things

Almost every highly successful tech company has a very high margin core business which essentially funds everything it does, including some activities with lower margins, and others which may be loss making (and effectively subsidized). Consider the following chart:

Highly profitable cores

A highly profitable core business allows these companies to do two significant things:

  • Offer secondary products and services at a variety of lower margins, ranging from negative to moderately positive, which can significantly add to the value of the ecosystem built around the core product(s)
  • Experiment with and invest significantly in new products and services without driving the whole business into the red.

There’s one big exception to the rule

Now, can you think of a major tech company which doesn’t fit this pattern? Has one come to mind? To my mind, Amazon is the one major tech company which doesn’t fit. Amazon lacks a highly profitable core: its core business of retail is inherently low margin. Even with a low margin core, Amazon has engaged in some of the same strategies as the other major tech companies, such as offering hardware at or close to cost (and therefore thin or zero margins), and bundling in connectivity to its Kindle devices on a subsidized basis. However, the end result is Amazon – unique among these major tech companies – is only minimally profitable in most quarters. And, at times when the company feels the need to experiment and invest in new products and services (or in growth), its margins head significantly into the red, as they have the past two quarters and are likely to continue to in the short term. To be sure, Amazon has two growing businesses which promise to be more profitable than its core of retail: third party sellers and Amazon Web Services. But neither is its core business and both are dwarfed by its first party commerce business.

Moving beyond one profitable core

The next thing that’s interesting to look at, especially in the context of recent earnings releases, is what happens when a company’s original highly profitable core starts to run out of steam. This usually happens for one of two reasons (and possibly both):

  • The product or service begins to saturate the addressable market and therefore growth opportunities diminish
  • The product or service begins to face significant competition, loses share and/or struggles to maintain high margins.

If we look again at our list of examples from above, we can see some interesting trends in terms of how these companies have responded to this challenge, as follows:

Apple – replicating the original model with new products

Apple has always faced a significant challenge in that its original product faced a fairly small addressable market, limited by Apple’s focus on high margin, high priced products. As such, Apple has had to layer on additional products using the same basic model (tightly integrated hardware and software) over time, and has successfully made the unusual transition from one highly profitable product to multiple, with the iPhone the highest margin of all. Apple is in the enviable position of having discovered a model which is replicable in the form of multiple highly profitable cores, creating enormous margins which have allowed it to fund many other businesses, some of them lower margin and others provided free to users.

Facebook – already planning for future cores

Facebook is a much younger company, and still growing very rapidly, with pretty decent margins. News feed ads in its mobile app (and to a lesser extent other ad products) have become its highly profitable core. But the company is already looking forward to future businesses which can augment and, if necessary, replace it over time. On this quarter’s earnings call, Mark Zuckerberg talked about three time horizons and the products on which it will focus in each of these phases: core products including video, public content and better ads in the next three years; Instagram, messaging and Search in the next five years; and Oculus and Internet.org over the ten year time horizon. I think these moves are entirely sensible, but they come at a cost. Facebook’s stock price took a hammering Tuesday night as it became clear in Facebook’s guidance for Q4 and 2015. A highly profitable core insulates a company to some extent against those effects, but Facebook’s core is neither big nor profitable enough yet to provide a complete buffer.

Google – replicating success with ads but also looking beyond them

Google’s profitable core is search advertising, with display ads providing a useful but somewhat less successful secondary product. The company has also aggressively pursued other ad opportunities, notably video advertising through YouTube. Taken together, all these products continue to deliver both high growth and high margins for Google. But Google clearly sees the potential for this growth and these margins begin to shrink and it’s investing in a hodgepodge of other initiatives. What’s odd about Google is it is applying the same skill sets (machine learning, AI, automation and so on) to some of these new projects, but not the same business models. Self-driving cars, tackling thorny health issues and so on benefit from Google’s unique capabilities, but it’s far from clear how Google will  monetize these or whether it even intends to. That’s the key challenge for Google – unlike Apple, its core business model doesn’t extend well to other areas.

Microsoft – one core holding up better than the other

Microsoft has had two cores: Office and Windows. The company has stopped reporting profitability on a product level, but when these two represented operating divisions at Microsoft, they generated over 90% of its substantial profits. That’s the very definition of a highly profitable core. But one of these cores – Windows – is under significant threat and Microsoft clearly realizes this. It’s already stopped charging license fees for devices under a certain size and it’s highly likely Windows 10 will be a free upgrade for Windows 8 users and possibly highly discounted for other users, too. The revenue opportunity (and therefore the margins) around Windows look dicey for the next several years. Office is holding up better, as the company transitions to a service model. Meanwhile, the company is investing heavily in cloud services, which are growing rapidly and promise to be a potential future core for Microsoft. However, Microsoft’s other initiatives aren’t yet paying off in quite the same way and it’s carrying quite a few less- and un-profitable businesses which need to be funded somehow. This is, in some ways, Microsoft’s biggest challenge: how to fund Xbox, Lumia, Surface, Bing and other non-core products as the cash cows start providing less milk?

Other companies face similar challenges

You can look at other companies using the same model. Do they have a profitable core? Is it healthy? How long will it remain so and what might replace it in time? Is the company clearly considering the need to plan for such an eventuality and do its plans seem realistic? We’ve already talked about Amazon. Twitter is another high profile tech company which has yet to find its highly profitable core, and continues to be loss-making even as it attempts to expand into new areas. Yahoo, AOL and many others also continue to struggle to find their profitable cores (AOL is a cautionary tale of what can happen if you fail to plan for the demise of a profitable core in the shape of its dial-up business).

One last lesson: look for what’s becoming pervasively non-core

One of the most fascinating things about this approach to looking at big tech companies is one company’s core is another’s non-core and vice versa. Thus, Microsoft’s core has been software, an area where Apple and Google now make almost no money as they subsidize software with hardware and ad revenue respectively. But there are certain areas which are becoming pervasively non-core – i.e. those products and services which almost no one sees as core and which are increasingly being given away for free. Those have come to include messaging and cloud storage, among other things. Creating standalone businesses around those services will become increasingly tough as a result. But of course, unless your company’s name is Microsoft, you’re also giving operating systems and productivity software away for free, which continues to be a major challenge to Microsoft’s business. So far, it’s been able to resist the implications of those moves but having your two core businesses going up against free competitors will be increasingly difficult.