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Why Google's Gross Margin Is Declining


IMAGE SOURCE: FLICKR/ROBERT SCOBLE.

Google spends a lot of money to get its ads and websites in front of people. The Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) company pays publishers a percentage of revenue to use its ad products on their sites. And it also pays Web browser developers, namely Apple (NASDAQ: AAPL), to make its search engine the default when users type a query into the address bar. It calls these expenses "traffic acquisition costs."

During the first quarter, Google's traffic acquisition costs (TAC) as a percentage of revenue from its network members' sites skyrocketed 2 percentage points, from 68% to 70%. Overall, TAC increased 13% year over year, which is in line with what would be expected, but a larger percentage of those TAC are going to publishing partners, which should worry investors.

The shift to mobile
As Alphabet CFO Ruth Porat noted several times on the company's earnings call, Google has higher TAC on mobile than on desktop for its own sites. That's largely because it gets a higher percentage of revenue from distribution partners on mobile compared with desktop.

Google's own Web browser, Chrome, has a pretty hefty share of the desktop market. The only browser with a share higher than its 31.3% is Internet Explorer, which still commands half the market, according to NetMarketShare. Google only pays distribution costs for about 5% of browsers on desktop.

Apple is much more dominant on mobile, however, which means a higher percentage of traffic to Google's search engine comes through Safari. Google reportedly paid out $1 billion to Apple in 2014, with the revenue share reaching 34% at one point in time, according to Bloomberg.

Over the past few years, while mobile Internet browsing blew up, desktop browsing increased as well. However, in the past few months, desktop browsing has started to decline, dipping 7.6% in January, 2% in February, and 6% in March, according to data from comScore.As more traffic moves to mobile, Google has to pay more to its distribution partners such as Apple.

But when asked if the company received a bump in TAC from a major renewal deal -- hinting at a deal with Apple -- Porat dodged the question and repeated her answer that mobile TACs are higher than desktop. So it's unclear if Apple has already renewed a deal with Google at a higher rate, or if that's a threat that still looms large.

Programmatic cutting in as well
While more search traffic is moving to mobile, Google also saw a jump in programmatic advertising on its network partners' websites. Programmatic advertising allows businesses to buy ads in real time using computer software to make the ad purchase. The process allows businesses to finely tune their ad targeting, which enables them to receive better return on investment.

In January, Google rolled out its Programmatic Guaranteed program, which allows advertisers to buy a guaranteed number of impressions on a publisher's website. This may have contributed to a bigger than usual rise in programmatic advertising, which Porat says also sees higher TAC than its standard display ads.

Programmatic is only going to become a larger part of Google's business. according to a survey from AdRoll, 66% of marketers plan to increase their programmatic ad spend in 2016. The number of businesses spending more than half their ad budgets via programmatic ads more than doubled last year, after doubling the year before.

As programmatic becomes a larger part of Google's business, TAC will become a larger part of its gross revenue. Combined with the shift to mobile, and a potential squeeze from Apple if it renegotiates its distribution agreement, Google could start to see its TAC rise faster than anticipated. While the growth of mobile has led to strong top-line growth for Google, the shift away from desktop browsing and the trend in programmatic advertising will result in slower bottom-line growth going forward.