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Diversity — and diversification — continues at big tech companies

Non-core businesses were a definite theme throughout the earnings reported over the last couple of weeks.

This is an image of Alphabet, Google’s parent company, CFO Ruth Porat.
Alphabet CFO Ruth Porat recently announced Q2 earnings, including for Other Bets, which encompasses everything that’s not part of Google, including self-driving cars, Nest, its venture arm, Verily and so on.
Michael Kovac / Getty

A version of this essay was originally published at Tech.pinions, a website dedicated to informed opinions, insight and perspective on the tech industry.

Employee diversity numbers were in the news this week, as Apple announced new figures that 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 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 percent operating margins for the Other Bets as a whole, and a significant overall loss despite revenue less than 1 percent 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 is 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 percent of Amazon’s overall revenue.

The bigger picture here is Services in general, which made up 31 percent of Amazon’s revenue in Q2, and 28 percent over the past 12 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 percent of total units sold in Q2, up from 40 percent two years ago and 30 percent 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 percent of revenue a year ago to 11 percent 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 has 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, seems to be delivering fantastic growth in both revenue and profit, 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 is very much in evidence in its financial reporting. In the fiscal year just ended, Microsoft generated 5 percent of its revenue from Surface alone, with another 4 percent from Phone and 11 percent from Xbox hardware, software and services, for 20 percent 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 percent of revenue at Microsoft in the past year, up from 6 percent a year earlier and 3 percent 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 percent 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 revenue and profit 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.

Jan Dawson is founder and chief analyst at Jackdaw, a technology research and consulting firm focused on the confluence of consumer devices, software, services and connectivity. During his 13 years as a technology analyst, Dawson has covered everything from DSL to LTE, and from policy and regulation to smartphones and tablets. Prior to founding Jackdaw, Dawson worked at Ovum for a number of years, most recently as chief telecoms analyst, responsible for Ovum’s telecoms research agenda globally. Reach him @jandawson.

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