Should Apple Make Its Own Search Engine and Cut Google Out of the Mix? – The Motley Fool

There's no shortage of rumors when it comes to Apple (AAPL 0.23%) and new tech hardware. Remember the Apple TV (Apple of course offers plenty of services for the television)? Rumors (or maybe hopes) still circle about a possible Apple Car, and there are persistent rumors that an Apple AR/VR headset is reportedly in the works.

But it isn't just hardware. There's also persistent speculation that Apple is building its own internet search service, too. That would be bad news for Alphabet (GOOGL -0.58%) (GOOG -0.36%) and its main breadwinner, Google. But would Apple really pull such a move and cut Google out of the mix in its lucrative hardware empire?

First, a quick primer. To this day, Apple's empire is predominantly based on hardware sales -- and it's done a great job getting consumers into its ecosystem (which includes Macs, iPhones, iPads, Watches, etc.) and keeping them there. It's a classic land-and-expand strategy: Once a sale is registered (an iPhone, for example), Apple can then push other device types by touting how tightly integrated all of them are.

But the device-focused business model has been slowly changing over the years. Software and other revenue not tied to a computing device sale -- the services segment -- hauled in revenue of $19.6 billion in Q3 of Apple's 2022 fiscal year (which ended June 25). That was a 12% increase from the year prior and represented nearly 24% of total revenue, making services Apple's fastest-growing segment.

Alphabet comes from the other side of the equation. It's a software business and monetizes primarily via advertising. It's been slowly edging into the hardware game, but ads remain the key driver of its internet business. Access to Apple's global installed base of devices currently in use (homing in on 2 billion active devices, the majority of them iPhones) is a big deal for Google. It reportedly shells out billions to be the default search engine on Apple devices.

Neither Apple nor Google actually discloses what Google pays Apple for internet search privileges. But estimates point to it being $15 billion in 2021, growing to a range of $18 billion to $20 billion in 2022.

In other words, a significant amount of growth in Apple services (and a sizable chunk of that revenue segment overall) is derived from internet search advertising.

Since Apple tightly controls its ecosystem of devices, why not just use those hefty payments from Google to build its own search engine and eventually drop Google entirely? It might make sense one day. After all, Google's ad business generates pretty healthy profits, even after the sizable traffic acquisition costs (TAC) paid to Apple. In Q2 2022 alone, Google's own services segment (primarily consisting of advertising) generated an operating profit of $22.8 billion, a profit margin of 36%.

By the way, Alphabet's TAC payments are where the Apple royalty estimates come from in the first place. Alphabet says Google's TAC has surpassed $24 billion through the first half of 2022. If Apple's mobile operating system is just over half of U.S. market share and close to 30% globally (Alphabet's Android making up the balance), estimates imply that roughly 40% of that TAC (or between $18 billion and $20 billion) goes to Apple each year.

Apple could already be testing the waters for a rival internet search engine. After all, there's already antitrust regulatory scrutiny over Apple accepting payment from Google in the first place. But besides that, Apple has already monetized search via ads for years in its App Store. Software developers can pay Apple to promote their app so it reaches more Apple users' eyeballs.

But then there's Apple's new activity-tracking transparency (ATT) feature (it's a prompt Apple sends you asking if you want to opt in to an app tracking your device usage activity). Apple has touted this feature as proof of how much it cares about your privacy. But plenty of developers and marketers out there claim Apple is using ATT to limit outside companies' access to users' data and promote its own advertising channels (which do have access to user data) within its massive base of devices. Given that the sale of devices overall has slowed over the years and considering Apple's increasing emphasis on services, building its own ad empire makes sense from a financial standpoint.

In fact, reports suggest Apple is aggressively ramping up hiring for its own in-house advertising segment. Apple's ads segment might already be redirecting billions of dollars a year in targeted advertising in-house with the help of ATT, while also making it harder for Google, Meta Platforms (that is to say Facebook), and others to sell highly profitable targeted ads. If the claims are true, Apple weakens other marketers' ability to sell ads to iPhones and the like while it simultaneously promotes its own targeted ad channels instead.

How does this relate to the development of an Apple internet search engine? Building an ad business -- the primary means of monetizing internet search, at least today -- could be the eventual precursor to Apple going head-to-head with Google. However, cataloging the internet itself is a massive task that requires the ability to collect and crunch a mind-boggling amount of data. Google owns a couple of dozen data centers around the world and rents lots more space for its servers in third-party data centers. Even for Apple, building the right infrastructure for a proper internet search service would be a tall order. $20 billion a year from Google would go only so far toward building new internet infrastructure, not to mention the massive amount of software development needed on top of it.

Given this, I think Google will safely remain the default search engine on Apple for the foreseeable future (unless regulatory factors come into play first). Apple is likely more than happy to collect those annual payments of tens of billions of dollars from Google. I see the status quo in internet search remaining intact for some time since it simply makes financial sense for both Apple and Google.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients have positions in Alphabet (C shares), Apple, and Meta Platforms, Inc. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Meta Platforms, Inc. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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Should Apple Make Its Own Search Engine and Cut Google Out of the Mix? - The Motley Fool