Peering Inside Google’s $19 Billion Black Box

There's a $19 billion black box inside Google. That's the yearly amount Google pays to companies that help generate its advertising sales, from the websites lined with Google-served ads to Apple and others that plant Google's search box or apps in prominent spots. 

Investors are obsessed with this money, called traffic acquisition costs, and they're particularly worried about the growing slice of those payments going to Apple and Google's Android allies. That chunk of fees now amounts to 11 percent of revenue for Google's internet properties. The figure was 7 percent in 2012. 

The worry is the traffic toll will keep climbing and squeeze the plump Google profit margins investors love. Let me add a risk that is so far theoretical but nevertheless intriguing. Google's traffic fees might go higher because of one of the biggest threats facing the company: the possibility of increased regulation in Europe or the U.S. 

These Google traffic fees are the result of contractual arrangements parent company Alphabet Inc. makes to ensure its dominance. The company pays Apple to make Google the built-in option for web searches on Apple's Safari browsers for Mac computers, iPhones and other places. Google also pays companies that make Android smartphones and the phone companies that sell those phones to make sure its search box is front and center and to ensure its apps such as YouTube and Chrome are included in smartphones.

In the last year, Google has paid these partners $7.2 billion, more than three times the comparable cost in 2012. Details of these financial arrangements are secret, but analysts think that the biggest culprit in the recent cost uptick is a revised agreement Google struck with Apple a couple of years ago. Analysts think this contract costs Google $3 billion to $4 billion a year, or perhaps much more.

Lately some Google watchers have said investors shouldn't panic about the traffic fees. Baird recently estimated the growth rate of traffic acquisition costs is likely to ease off this year or in early 2018, in part because Google is past the worst of the cost increases from its revised Apple contract. 

But there's another wild card that may push those costs up. European antitrust authorities are investigating whether Google's arrangements with Android phone manufacturers and phone companies constitute an abuse of the company's power. Companies enter these arrangements with Google voluntarily. But if manufacturers want to include some popular Google apps such as the Google Play app store, they are often required to take other Google apps, too, and set Google search as the default option.

Google has said its Android model is healthy for consumers and business competition, and the investigation is likely to take years to play out.

In the meantime or in the event of a antitrust action, Europe's scrutiny might give Google's partners more leverage to demand higher traffic fees or wriggle out of aspects of their agreements. RBC Capital Markets analyst Mark Mahaney recently estimated that each percentage point increase to traffic acquisition costs would drain about 1 percent from Google's estimated earnings next year, or roughly $280 million in profit. 

There is some precedent that should worry Google watchers. Earlier this year, Google settled a monopoly dispute with Russia and agreed that it would no longer require local Android phone manufacturers to make Google the default web search on their devices. It's not clear whether Google has taken a financial hit, but investors in Russian web search company Yandex NV think the company now has a leg up over Google. Yandex shares have climbed about 43 percent since the Google settlement.

Google is changing its business in ways that might mitigate its traffic bills. The company is making more homegrown hardware, including smartphones and other gadgets Google introduced last week. If Google's hardware market share goes up, it may need to pay less to partners such as Apple. For now, however, Google sells relatively few phones or other gadgets. That means for the foreseeable future, the majority of people using Google search and other services will come through partners that collect the Google traffic tax. 

The focus on Google's rising traffic costs also shows the general profit pinch facing the technology superpowers. Google, Facebook Inc., Microsoft Corp. and other companies are branching into new areas that drag down profit margins. It's also possible that Google and Facebook will be forced to apply more oversight to their advertising systems to guard against the types of misuses exposed after the U.S. presidential election. Google investigators recently found evidence of Russian accounts purchasing ads to sow misinformation in the U.S. More oversight of the companies' advertising could mean more people and a drag on profits.  

That's not to say Google, Facebook and other tech giants won't stay profitable beasts in absolute dollars, but each dollar of fresh sales may get progressively less profitable over time. In short, there's a risk that being Google is simply getting more expensive. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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