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February 12th, 2019: Viral AirPods, Amazon to Buy Eero, Estimating Apple’s Google TAC Revenue

Speaking of hardware start-ups getting acquired prior to IPO, Amazon announced it will acquire Eero, a mesh Wi-Fi router start-up. We will go over the development in today’s update.

However, we will kick things off with AirPods.

Viral AirPods

There is a fascinating story to tell about AirPods.

Two months ago, we discussed how interest in AirPods had started to surge. Search interest, as measured by Google Trends, was up 3.5x year-over-year this past Black Friday. That type of year-over-year change is abnormally high for an Apple product.

In the following weeks, I kept an eye on Google Trends data and things turned even more remarkable. During the holiday week (Christmas through New Year’s), search interest for AirPods was up 5x year-over-year.

This got me thinking, What is happening with AirPods?

After a few weeks of work, my conclusions are found in the latest Above Avalon weekly article, “AirPods Have Gone Viral.”

AirPods have been available for nine quarters. Here are cumulative unit sales as of the ninth quarter of availability (AirPods and Apple Watch figures are my estimates):

iPad: 84M
AirPods: 37M
iPhone: 34M
Apple Watch: 27M
iPod: 2M

iPad was an outlier when it comes to early adoption. The device was able to ride the iPhone’s coattails perfectly.

AirPods sales have exceeded Apple Watch sales at the same point after launch by nearly 40%. Some of that isn’t too surprising given AirPods' $159 price and the fact that the case for wireless headphones is easier to make than a new kind of utility on the wrist.

Upgrade trends make a big difference when thinking about cumulative unit sales. For AirPods, we can probably include replacement trends to account for people buying a second pair of AirPods after losing the first pair. Early iPhone sales benefited from a two-year upgrade cycle. We haven’t seen a similar upgrade pattern for Apple Watch. It remains to be seen how AirPodsupgrading will trend.

When taking into account upgrading, one way of thinking about the cumulative sales is the size of the installed bases by the end of the third year of availability.

iPad: 118M
iPhone: 55M
AirPods: ~50M
Apple Watch: ~30M

However, when it comes to the item that stood out to me the most from the article, we have to turn to the reasons behind AirPods going viral.

High Visibility. AirPods are literally hanging out of people’s ears. They are difficult to miss when worn.
New and Different. The product is intriguing, sparking curiosity.
Social Signaling. Wearing AirPods signal to others that the wearer likely has an iPhone and is able to pay $159 for a pair of wireless headphones despite a wired pair being included in the iPhone box.

There is a commonality found with the three preceding factors. It may sound incredibly simple and straightforward, but consensus has likely overlooked this item.

People want to wear AirPods and be seen wearing them. They're cool. They have the "it" factor.

It brings back memories of the iPod days.

The lack of genuine competition in the wearables space has caught many people by surprise. However, when thinking of reasons behind the lack of competition, many people in tech circles have pointed to technology (or the lack thereof) as the culprit.

In my view, Apple's most important competitive advantage with wearables hasn't been found with tech performance. Instead, it's been related to fashion and design. Apple Watch and AirPods adoption have been driven by people wanting to wear these devices and, maybe even more importantly, wanting to be seen by others wearing the devices.

What is going to happen when Amazon launches its own wireless headphones? Voice advocates may jump up and down in excitement. However, will people want to be seen wearing items known as digital assistant conduits before anything else? I'm skeptical.

For the past few years, Apple has demonstrated the capability to come up with cool products that people want to be seen using and wearing. While that may seem a bit superficial, for wearables it represents a key ingredient for success.

When thinking about a pair of lightweight smart glasses, the only way Apple will succeed with such a product is if people want to be seen in public wearing them. It's that simple. Yes, the value proposition has to be there to sustain interest. The technology has to be compelling in order for consumers to crave a space for the product in their lives. However, the value prop and technology will only matter as long as people want to wear the device in the first place.

The major takeaway from AirPods going viral is that Apple has a product on its hands that people want to be seen wearing. It's going to be very difficult for other companies to recreate the phenomenon.

Amazon to Buy Eero

Here’s Amazon in a press release:

“Amazon and eero today announced that they have entered into a definitive merger agreement under which Amazon will acquire eero. eero’s home mesh WiFi systems set up in minutes and blanket every room of a customer’s home in high-performing, reliable WiFi. eero is already delighting Amazon customers with its products and services, as indicated by eero’s 4.6-star product rating on Amazon.com.

‘We are incredibly impressed with the eero team and how quickly they invented a WiFi solution that makes connected devices just work,’ said Dave Limp, SVP of Amazon Devices and Services. ‘We have a shared vision that the smart home experience can get even easier, and we’re committed to continue innovating on behalf of customers.’

‘From the beginning, eero’s mission has been to make the technology in homes just work,’ said Nick Weaver, Co-Founder and CEO of eero. ‘We started with WiFi because it’s the foundation of the modern home. Every customer deserves reliable and secure WiFi in every room. By joining the Amazon family, we’re excited to learn from and work closely with a team that is defining the future of the home, accelerate our mission, and bring eero systems to more customers around the globe.’

eero uses multiple access points that work together as a system to blanket a home in high-performing, reliable, and simple home WiFi. Customers can customize an eero system to meet the needs of their home—regardless of shape or size—eliminating dead zones, ensuring perfect streaming video in every room, and delivering the bandwidth all connected devices need.”

This acquisition is all about Amazon grabbing user data within the home. Amazon wants to know more about you in order to then be in a better position to sell you stuff.

In a way, Amazon wants to know what you are going to buy before you even know it yourself. This will require knowing what devices you own, which devices you are using, and more importantly, how you are using those devices. When it comes to retail competition in the future, predictive purchasing will certainly classify as a competitive advantage.

The writing is on the wall.

We are moving to the point where a consumer will have the opportunity to go all-in on an “Amazon home” in which Echo speakers, microphones, locks, a security system, a Wi-Fi router, and various third-party smart appliances with Alexa built in are all connected to Amazon.

This is crucial for Amazon because the home has become an e-commerce engine. We are likely going to buy most of our stuff online within the confines of our home. In addition, our home is the delivery point for all of those goods. Said another way, Amazon needs to bet big on the home.

Being careful not to go off on too much of a tangent, this dynamic explains why Google’s home play feels less compelling. Amazon is a retailer looking to solidify its position in the place you are likely to buy most of your stuff. That makes sense. What’s Google’s message for the home? A vehicle to give you all of the information and knowledge you can ever want? It’s murky. Meanwhile, Apple’s aim is to sell you the most powerful and useful computing tools that you will use in the home.

The amount of pushback, at least on Twitter, to Eero announcing it was being acquired by Amazon was noteworthy. Consider the more popular responses to Eero’s tweet announcing the acquisition. Ouch.

(click/tap image to enlarge)

Something has definitely changed here because there would not have been a similar level of negatively if Amazon bought Eero a few years ago. Could we be seeing the first tangible signs of consumers being hesitant towards smart home devices given data privacy?

In my view, Eero was not a lost opportunity for Apple.

Apple could have acquired the start-up if it wanted. Eero has been around for a number of years and has more recently shown signs of struggling. The company’s products had plenty of press coverage, not all of it positive.

The more relevant issue is that there just isn't much rationale for an Apple acquisition here. It’s not as if Eero had significant share in the Wi-Fi router market or a product that Apple had to own.

There are a number of alternatives for consumers looking for mesh Wi-Fi routers (still pretty niche). For example, Apple currently sells Linksys Velop mesh Wi-Fi systems online for between $100 and $450.

Not surprisingly, this Amazon / Eero news has once again put a spotlight on Apple’s decision back in 2016 to get out of the wireless router business.

Apple's move was likely driven by a few factors:

Apple didn’t see the point in dedicating resources and attention to taking on chipmakers like Broadcom and coming out with a differentiated router.
Apple was planning on removing some of the features from AirPort routers that customers found valuable, like wireless music playback, and putting the functionality into a new kind of Apple device(s).

Over the subsequent two years, we saw the second point materialize with HomePod and AirPlay 2 supported speakers.

Following this Amazon / Eero news, there was a small, but vocal, group arguing Apple should get back into the wireless router business because of data privacy.

While that may make sense on the surface, is that enough for Apple? I’m not convinced.

It’s not as if the market environment today was terribly different two years ago when Apple decided to get out of wireless routers. One has to imagine Apple’s decision was made knowing competitors may decide to approach the Wi-Fi router market for other reasons, such as data collection.

There are other factors at play here when it comes to Apple and Wi-Fi routers, such as recent market trends in which a good number of people likely rent their router from their internet provider rather than set up a $400 mesh Wi-Fi network.

Another longer-term consideration includes Apple's philosophy regarding wireless connectivity in the home as we move into the wearables era. It is conceivable that every wearable device will one day require wireless connectivity in and out of the home.

My suspicion is that Apple is thinking more about connecting devices in and out of the home instead of just in the home.

Estimating Apple’s Google TAC Revenue

Alphabet, Google's parent company, reported earnings last week. From our perspective, the most interesting number is Google’s traffic acquisition costs (TAC). This is a key variable driving Apple's Services revenue line item.

As defined in Alphabet’s 10-K: one component of TAC includes “amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers.”

Google TAC (related to distribution partners)

2016: $5.9B (9.2% of Google properties revenues - the TAC rate)
2017: $9.0B (11.6% of Google properties revenues)
2018: $12.6B (13.1%)

According to Alphabet, the increase in TAC to distribution partners from 2017 to 2018 was a result of an increase in Google properties revenues and the associated TAC rate. The increase in the Google properties TAC rate was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points.

Read between the lines, and Google is referring to the new arrangement with Apple regarding positioning Google as the default search provider for web searches from Siri. In addition, it looks like Google is simply paying more for access to the same premium users.

We know that Google didn't pay Apple $12.6B in licensing fees in 2018. However, that's not telling us a whole lot. Consensus assumed Apple received a lower total than $12.6B from Google in 2018. Instead, the key variable to estimate is Apple's percentage of that $12.6B.

In 2014, Apple represented 28% of Google’s TAC to distribution partners.

My estimate is that Apple now represents closer to 60% of Google’s TAC to distribution partners.

Accordingly, Google likely paid Apple somewhere around $7B to $8B in TAC in 2018. In 2017, the total was closer to $4B. The strong year-over-year growth would explain Apple listing licensing as the largest driver of Services revenuegrowth ($3B to $4B year-over-year) in its most recent 10-K and 10-Q filings. As a comparison, App Store revenue growth was likely closer to $1.5B to $2.0B year-over-year.

In summary, roughly half of Apple's Services business is driven by two items:

App Store: ~$12B of revenue per year ($2B growth year-over-year)
Licensing (Google TAC and other revenue): ~$10B of revenue per year ($3B to $4B growth year-over-year)

My estimates match Apple's recent commentary that the single largest Services line item was less than 30% of overall Services revenue.

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