How Google gets rich off of Android system by pretending that it is “Open SOurce”

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Since Android was first released, many of us have wondered how open it really is. Last week, we learned more about Google’s (GOOG) tight control over Android through documents released as part of an European antitrust investigation.

The story was first reported by the Wall Street Journal, based on an analysis by Harvard professor Ben Edelman. (The WSJ said that Google declined to comment). The meat of the revelation were copies of the 2011-2012 “Mobile Application Distribution Agreement” (MADA) that was signed by Android licensees Samsung (OTC:SSNLF) and HTC(OTC:HTCCY). The agreements were exhibits in the Google-Oracle (ORCL) (née Sun Microsystems) Java copyright lawsuit in the Federal District of Northern California.

Ties That Bind

Rolfe Winkler of the WSJ summarized the (MADA) agreements as follows:

 

The Samsung and HTC agreements specify a dozen Google applications that must be “preinstalled” on the devices, that Google Search be set as the default search provider, and that Search and the Play Store appear “immediately adjacent” to the home screen, while other Google apps appear no more than one screen swipe away.

The terms put rival mobile apps, like AOL Inc.’s MapQuest and Microsoft Corp.’s Bing search, at a disadvantage on most Android devices. Mr. Edelman, who is a paid consultant for Microsoft, said the terms “help Google expand into areas where competition could otherwise occur.”

Google has successfully promoted its own apps on Android. Four of the top 10 most-used apps on Android smartphones in the U.S. during December were Google’s, according to comScore. On Apple’s iPhone, only one Google app—YouTube—was among the top 10.

 

Calling Edelman a Microsoft consultant seems like a red herring. More relevant is that he embarrassed Google by noting that it tracked user browsing even when users disabled it. Edelman seems an equal opportunity Internet activist, having spent his entire adult life at Harvard (earning an AB, AM, JD, and PhD in econ before becoming an assistant and associate professor at Harvard Business School).

In his own analysis, Edelman shows how Google’s activities constitute tying:

 

If a phone manufacturer wants to offer desired Google functions without close substitutes, the MADA provides that the manufacturer must install all other Google apps that Google specifies, including the defaults and placements that Google specifies. These requirements are properly understood as a tie: A manufacturer may want YouTube only, but Google makes the manufacturer accept Google Search, Google Maps, Google Network Location Provider, and more. Then a vendor with offerings only in some sectors—perhaps only a maps tool, but no video service—cannot replace Google’s full suite of services.

I have repeatedly flagged Google using its various popular and dominant services to compel use of other services. For example, in 2009-2010, to obtain image advertisements in AdWords campaigns, an advertiser had to join Google Affiliate Network. Since the rollout of Google+, a publisher seeking top algorithmic search traffic de facto must participate in Google’s social network. In this light, numerous Google practices entail important elements of tying:

 

 

If a wants Then it must accept
If a consumer wants to use Google Search Google Finance, Images, Maps, News, Products, Shopping, YouTube, and more
If a mobile carrier wants to preinstallYouTube for Android Google Search, Google Maps (even if a competitor is willing to pay to be default)
If an advertiser wants to advertise on anyAdWords Search Network Partner All AdWords Search Network sites (in whatever proportion Google specifies)
If an advertiser wants to advertise onGoogle Search as viewed on computers Tablet placements and, with limited restrictions, smartphone placements
If an advertiser wants image ads Google Affiliate Network(historic)
If an advertiser wants a logo in search ads Google Checkout(historic)
If a video producer wants preferred video indexing YouTube hosting
If a web site publisher wants preferred search indexing Google Plus participation

 

Not all tying is illegal. But tying by a dominant firm is legally suspect — even more so in Europe, where the competition policies are more aggressive (especially for US firms like Google).

Technically Open, Commercially Not

From a practical standpoint, phone makers have no choice but to comply with Google’s terms (with the exception of China’s domestic market, where Google’s services are blocked). As OSS IP maven Florian Muellerwrote:

 

Technically you can take the free and open parts of Android (in terms of the amount of code, that’s probably the vast majority, though the share of closed, tightly-controlled components appears to be on the rise) and build a device without signing any individual license agreement with Google, and some have indeed done so. If that is so, why did Samsung and HTC sign those agreements that have now come to light? For commercial reasons.

If you want your Android device to sell, you normally want to be able to call it an Android device. To do that, you need a trademark license from Google. Open source licenses cover software copyright, they may come with patent provisions, but licenses like the GPL or ASL (Apache) don’t involve trademarks.

The trademark — the little green robot, for example — is commercially key. In order to get it, you must meet thecompatibility criteria Google defines and enforces, which are mostly about protecting Google’s business interests: the apps linked to its services must be included. And those apps are subject to closed-source, commercial licensing terms. That’s what the MADA, the document Samsung and HTC and many others signed, is about.

Even if you decided that the trademark isn’t important to you, you would want at least some of the apps subject to the MADA. What’s a mobile operating system nowadays without an app store? Or without a maps/navigation component? Google gives OEMs an all-or-nothing choice: you accept their terms all the way, or you don’t get any of those commercially important components. And if you take them, then you must ensure that the users of your devices will find Google services as default choices for everything: search, mail, maps/navigation, etc.

 

 

This “free” software comes at a price. Even if Google doesn’t charge royalties to use its applications, the London Guardian estimated last month that it costs $40k-$75k to test a new handset for compliance with Google’s standards and thus be allowed to ship Google’s applications.

Google Isn’t Open About Not Being Open

Most troubling for me has been — since the beginning of Android — thegap between Google’s rhetoric of openness and the reality; for example, see “Open source without open governance” (June 2008), “Perhaps someday Android will be open” (July 2008), “Sharing in faux openness” (October 2009), “Google’s half-full glass of openness (January 2010), “Andy wants you to buy his openness (June 2010) “Semi-open Android getting more closed” (October 2013).

While these agreements have been in place for at least three years, Edelman notes that Motorola redacted the most important provisions of the MADA when it disclosed excerpts in a 2011 SEC filing. Google’s lack of transparency about its non-openness helps it be more successfully non-open:

 

MADA secrecy advances Google’s strategic objectives. By keeping MADA restrictions confidential and little-known, Google can suppress the competitive response. If users, app developers, and the concerned public knew about MADA restrictions, they would criticize the tension between the restrictions and Google’s promise that Android is “open” and “open source.” Moreover, if MADA restrictions were widely known, regulators would be more likely to reject Google’s arguments that Android’s “openness” should reduce or eliminate regulatory scrutiny of Google’s mobile practices. In contrast, by keeping the restrictions secret, Google avoids such scrutiny and is better able to continue to advance its strategic interests through tying, compulsory installation, and defaults.

Relatedly, MADA secrecy helps prevent standard market forces from disciplining Google’s restriction. Suppose consumers understood that Google uses tying and full-line-forcing to prevent manufacturers from offering phones with alternative apps, which could drive down phone prices. Then consumers would be angry and would likely make their complaints known both to regulators and to phone manufacturers. Instead, Google makes the ubiquitous presence of Google apps and the virtual absence of competitors look like a market outcome, falsely suggesting that no one actually wants to have or distribute competing apps.

 

 

With some irony, the WSJ article quoted Google’s former CEO:

 

“One of the greatest benefits of Android is that it fosters competition at every level of the mobile market—including among application developers,” Google Executive Chairman Eric Schmidt wrote to then-U.S. Senator Herb Kohl in 2011.

 

Peeling Back the Layers of Openwashing

While the most specific and conclusive, this latest revelation is not the only evidence that Android is more openwashing than open source.

For example, in October Ron Amadeo of Ars Technica listed all the cases where “open source” Android once came with a key application available in open source, but then Google orphaned the open source app when it brought out a fully-featured closed-source replacement. This includes the Search, Music, Calendar, Keyboard, Camera and Messaging apps.

At the same time, Google (with great success) sought to convince app developers to use the Google Play APIs rather than the official Android APIs — thus making these apps incompatible with devices that use only the open source part of Android (e.g. Amazon’s Kindle). If you want to use apps from the Google app store, you have to use the Google APIs.

Finally, there’s the matter of the Open Handset Alliance, the organization nominally leading Android development. Amadeo makes clear that OHA is more like the Microsoft Developer Network than the Eclipse Foundation (emphasis in original):

 

While it might not be an official requirement, being granted a Google apps license will go a whole lot easier if you join the Open Handset Alliance. The OHA is a group of companies committed to Android—Google’s Android—and members are contractually prohibited from building non-Google approved devices. That’s right, joining the OHA requires a company to sign its life away and promise to not build a device that runs a competing Android fork.

 

Google: Partly Open and Opening Parts

In the early 2000s, open source was a paradox. When I began researching my second open source article (which I used as a job talk in December 2001 and was published in 2003), it was not clear how firms could make money from something nominally open. Based on a study of Apple, IBM and Sun, I concluded that firms made money off of openness with strategies that were open in one of two ways: they opened parts (leaving other parts close) or they were partly open (granting some rights, but not enough to enable competitors).

Google is clearly doing both. Amadeo emphasizes that with Android, Google is only opening parts — leaving key components under tight control. Meanwhile, the latest news points to Google being only partly open: rights to use the “open source” (actually, a mixed-source) system depend on complying with a series of Google restrictions.

In 2011, mobile analyst Liz Laffan studied the openness of eight mobile-related open source communities. Building on a 2008 study I did with Siobhan O’Mahony, she developed a 13-factor openness score for firm controlled open source communities. In her report (summarized in a 2012 journal article) Laffan assigned scores from 0-100% open. Android was lowest at 23%, and in fact the only project less than 50%. At the other extreme, Linux was 71% and Eclipse (designed to be open from the start) was 84%.

Conclusion: Real World Android is a Proprietary Platform

In the 1980s and 1990s, Microsoft won commercial success by widely licensing its PC operating system to all comers. However, after the initial licenses (with its launch customer IBM), Microsoft largely dictated the terms of these licenses.

When people buy an Android phone, they are not buying the Android Open Source Project but (as Amadeo makes clear) the Google Play Platform. This platform — call it Real World Android — has the following characteristics

  • Like Apple’s (AAPL) OS X (or IBM’s WebKit), it combines open source and proprietary elements.
  • Like Windows, it is licensed to a wide range of hardware manufacturers.
  • Like both OS X and Windows, much of the value comes from bundling a wide range of proprietary, closed-source applications

In short, Real World Android is a proprietary platform: proprietary in that it is a mixture of open source and proprietary elements, but the complete platform (including application functionality and access to the Android app ecosystem) requires licensing proprietary technologies under a restrictive proprietary contract. (For a true open source system, the open source license would be enough).

A few market experiments (notably Kindle and the Chinese market) have been made using the Android open source project (which Amadeo dubs AOSP). For the remainder, as Florian notes, commercial success requires agreeing to Google’s terms to use its proprietary platform. If it was ever accurate to refer to Android as an open source platform, it’s clearly no longer true today.

Yes, by using an ad-supported (two-sided market) approach Google doesn’t have to charge royalties, but that doesn’t make it free (as in speech or as in beer). With 42% of the US mobile ad market — and Android accounting for the majority of US smartphones — Google makesbillions off of Android users. Google’s preloaded apps command choice real estate, and if Google didn’t control this real estate, handset makers could sell this real estate to the highest bidder.

So despite all the rhetoric, Google is just another tech company that wants to rule the world and make zillions for its founders and executives. It controls its technology to gain maximum advantage, and (like many firms nowadays) uses openwashing to render spotless its proprietary motivations. This shouldn’t be surprising. It won’t be a surprise for anyone who reviews the how Android evolved (and the strategy emerged) over the first five years.

 

Professor, tech, energy
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Software is Eating the World

In the good old days you bought a computer and it had hardware. You bought IBM, or Honeywell or DEC and that became your world: hard or soft it was all from one company. Now software is flexing its muscles and Google’s Android software packages are a key element. They have become what UNIX hoped to become.

Apple is swimming strongly against the tide. They feel that if you like their software you will have to buy their hardware. And to a very large extent that is true. Let’s call this model A.

Elsewhere, cheap chips mean cheaper tools. Wholesale prices of bottom of the line Android phones are under $50. Google sells the operating level of the software and thousands of hackers and small firms and rapidly growing firms make the software gadgets that some of these users want. If the potential market for your $8.95 software gadget is a billion plus [as of September 3, 2013, 1 billion Android devices have been activated] then you need a tiny percentage of that to be profitable.

The Android software is based on Unix principles and Open Source philosophy. Android was unveiled in 2007 along with the founding of the Open Handset Alliance: a consortium of hardware, software, and telecommunication companies. So although it’s not a huge cash generator for Google, it shows them building a different customer-ecology than Apple and demonstrates their software expertise.

At the moment then, Google is sitting on a mound of cash from its main source of revenue: on line ads and clicks. Here’s a summary from Rizzi Capital.

Nov 20 2013, 08:59                              by: Rizzi Capital  |              about: GOOG

Google (GOOG), the third largest company by market cap in the world has been on a tear lately. It’s shares are trading just shy of an all time high, and investors are rejoicing. And soon, shareholders will have another reason to cheer – Google may be just a few months away from announcing its first dividend. The blogosphere and analysts have been buzzing with speculation on this subject for the last year, and now the writing may be on the wall.

Google fights every day to win over consumers, and the Google investor relations team works diligently from morning to night working to please investors. With major tech competitors such as Apple (AAPL), Microsoft (MSFT) and Cisco (CSCO) all returning huge shareholder value via buybacks and dividends, Google will have little choice but to join the tech stock dividend bonanza. Considering Google’s massive cash hoard and abundant free cash flow, it seems like a very small price to pay.

Cash Is Flowing

Google has always been a cash flow generating machine. Its basic core business model of selling advertising space on the back of its search engine results required low capital expenditures and provided fat profit margins. As Google expanded its offerings and made some expensive acquisitions, such as YouTube, DoubleClick and Motorola, as part of its growth strategy, its cash flow generation slowed marginally. However, now, under the leadership of CEO Larry Page, it has integrated most of its businesses and is focusing on strategic, organic growth opportunities. Cash flow is once again powering higher at an accelerating rate and capital expenditures are remaining rather tame.

The chart below shows Google’s net operating cash flow as well as its capital expenditures.

(click to enlarge)google cash flow

It’s always a beautiful thing to see. As net operating cash flow has increased dramatically since 2009, capital expenditures seem to have reached a plateau. In 2013, a year which is not shown in the chart, the numbers only get better.

A cash flow of this size is something which few companies can brag about, and it’s an enviable problem to have. Google has been storing away a large portion of the cash on its balance sheet, and has accumulated more than $50 billion so far. This is more than enough cash for the company to have on hand for any foreseeable capital expenditures. Furthermore, given their debt level, stock price, and the current rock-bottom financing costs, Google would have ample resources available if it wanted to make a major acquisition in the future. There is just no good reason for the company to continue stockpiling cash.

Options

The company fundamentally has two main options. Google can either use their cash to buy back shares on a massive scale, or they can institute a quarterly cash dividend. Either one of these options would be applauded by shareholders, but one option is more likely than the other.

In terms of a share buyback, we should note that Google shares are currently trading near an all time high at over $1000 per share. I know Google. I love Google. But can the company really justify a massive share buyback? Even though Google operates in a virtual monopoly and it is growing rapidly, investors would be hard pressed to say that the shares are cheap based upon any commonly accepted valuation methods. Apple recently announced a massive share buyback worth $60 billion. But Apple has a P/E ratio of 13.12. By comparison, Google’s P/E ratio is 29.5. That’s not exactly discount territory.

In addition, it should be noted that Google “only” has a cash hoard of about $50 billion, of which only 20% is held onshore. Considering that Google’s present market cap is over $300 billion, a small share buyback valued at under $10 billion, would not be particularly meaningful.

For this reason, the most likely course of action will be for Google to institute a dividend program similar to that of its rival, Apple. The program will likely start small, with quarterly payments, and then rise as cash flow continues to increase. For comparison, when Apple initiated its dividend program, the initial payout ratio was about 12% in the first year but was boosted to almost 30% in the second year. Google would likely follow a similar path. At a 12% payout ration, Google would have an initial dividend of about $5 per year, based on analysts 2014 earnings per share estimates of $43.50. Although a dividend of this amount would not compute to a very high yield, it would send a clear message to investors that Google is committed to return value to investors, and not only through price appreciation of its shares.

At the same time Google would be retaining a large enough portion of its cashflow to fund any foreseeable acquisition or to implement a share buyback if market conditions would warrant it. Analysts are predicting that by 2016 Google will have free cash flow of over $20 billion per year. Google would clearly be able to adjust the dividend higher as the cash flows increase.

Counter Arguments

Some analysts have been vocal that Google will not implement a dividend policy for at least 2 more years. These analysts state that Google will want to hold on to as much cash as possible in order to finance a possibly huge acquisition. They claim that until Google reaches the goal of having $100 billion in the bank, it will not return value to shareholders via a dividend. To be honest, I dismiss these claims.

Google is now the largest company in the world not paying a dividend. It has made large acquisitions in the past, such as Motorola and Youtube, but when we really compare these purchases to the massive size of Google’s cash balance, they are minor. Google is a tech company headed by a CEO who is focused on changing the world. Larry Page pumps Billions of dollars into R&D and projects like Google Glass and Google X. From time to time there may be a complementary acquisition which might help further his endeavors, but ultimately Google does not have the culture or history of making massive acquisitions which would radically affect the company. Larry Page has his eyes set on using Google’s cash reserve on research and development to create revolutionary products from scratch. These so call “moonshot” projects require large development costs, but given Google’s size, they do not make a significant impact on cash flow.

“While they’re-in absolute dollars-probably significant amounts, they’re not significant for Google, and I think you should actually be asking me to make more significant investments. I wish I knew how to do that,” – CEO Larry Page, when asked about Google R&D expenditures.

Furthermore, stating that the company would choose to only start paying a dividend once it had $100 billion in cash on the balance sheet is arbitrary. Google is already facing scrutiny from the government because of it’s low tax rate and high offshore cash reserve. Would it really want to make global headlines by declaring it had achieved the dubious honor of joining the $100 billion club?

Bottom Line

Google is a company which is growing rapidly and generating more cash than it knows what to do with. It has a war chest worth over $50 billion, and will likely not want to keep adding to that number for very much longer. As all other large technology companies have started paying dividends, shareholder pressure for a return of value is intense and will only increase. In a situation like this, shareholders will inevitably be rewarded. All the elements are in place for Google to implement a dividend policy next year. While it will likely start with a low payout ratio as compared to competitors, as cash generation accelerates, shareholders will be rewarded with a rapid dividend increase. Look for an initial quarterly dividend of $1.25, or $5.00 annually, and expect it soon.