16 Jan 2014

Google Buys Nest: Business Model Remains Unchanged

Google - Nest Valuation

Earlier this week, Google acquired Nest labs for $3.2 billion. Nest manufactures internet connected thermostats and smoke alarms and was co-founded by former Apple executive, Tony Fadell. As with every other Google acquisition, this evoked a multitude of reactions from industry observers. Let's take a look at a few commonly held misconceptions and the likely rationale for this acquisition.

Google is not a Conglomerate

Let's begin with the obvious - No, Google is not turning into a conglomerate. This theory has been put forward because of Google's tendency to operate acquired companies independently. Google has used this strategy with every acquisition that wasn't directly related to its advertising business (or one that wasn't a technology/employee acquisition). Products like YouTube and Android are integral to Google's strategy today, but were operated as independent companies when they were acquired.

This strategy ensures that there are no hiccups in the product development/iteration processes after the acquisition. Over the long-term, this allows Google to use these products as a channel to integrate their services, mine data that can be monetized and use that data to create new services. This is the primary goal of the Nest acquisition.

Google is not an Integrated Devices Company

Another commonly held misconception is that Google's interest in consumer products (self-driving cars, Google Glass, Motorola acquisition, etc.) suggests an intention to pivot to a hardware-based business model. Nothing could be further from the truth. I've already explained that any attempt to monetize both hardware and services is unlikely to work and will only create internal conflict. Google's strategy with Motorola has already proved that they have no interest in hardware margins. This means that Google is only interested in consumer devices as a means to distribute services and acquire data.

Entering consumer device markets early with integrated low margin products could prevent other integrated hardware companies like Apple & Samsung from gaining a foothold with comparable high margin products. Think of it this way - the iPhone's high price/margins created the conditions necessary for Samsung to succeed. The Nest acquisition gives Google the option to keep device prices/margins low and mold the market to cater to their business model.

Google's Advertising Revenue in the Mobile Era

These misconceptions stem from a misunderstanding of Google's business model and their long-term revenue drivers. One pattern commonly used to support these theories is that Google's revenue is highly correlated with the global internet population. The problem with that pattern is that it is almost entirely based on data from the personal computing era. Until mobile browsing reaches critical mass, we will have no knowledge of how this pattern will evolve. Therefore, assuming a flat ARPU isn't necessarily a good assumption when the underlying factors are no longer constant. This is especially true when we take into account the fact that Google has still not implemented any monetization strategies for mobile-focused services like Google Now. Google's business model will certainly force it to explore novel ways of monetizing these mobile services. Unfortunately, operating independent hardware companies will not be one of them.