Microsoft & TikTok: The Odd Couple (Part 2 of 2)

 

Microsoft & TikTok: The Odd Couple (Part 2 of 2)

In the last post, I laid out the much-needed context to understand this acquisition in more detail. In this blog post, I will introduce the proposed deal structure and analyze the potential strategic benefits to Microsoft from this transaction and finally present my arguments as to why this may not be the best deal for Microsoft.

Source: Techonomy

By now it would seem clear why Microsoft’s interest in TikTok is unusual. For nearly half a decade, Microsoft has been focusing successfully on the unglamorous but highly profitable enterprise market and has managed to remain out of the headlines while growing the business successfully. Why does Microsoft now want to enter the muddy waters of a video-based social media platform that has been a lightning rod for political and regulatory scrutiny?

To understand the acquisition, it is important to understand the proposed deal  structure  in a little more detail.

The Complex Deal Structure

While the specifics of the deal are wrapped up in secrecy at the moment, what we do know is that Microsoft is looking to acquire TikTok’s operations in the US, Canada, Australia and New Zealand. These countries are part of the Five Eyes intelligence alliance. UK is left out of this deal since ByteDance is looking to move its headquarters from Beijing to London and does not want to relinquish control of their UK operations. It appears that ByteDance might be looking to sell its European operations in a separate deal down the line. According to Microsoft, the takeover would offer users “world-class security, privacy, and digital safety protections”. This is obviously a key reason why the US is pushing for the deal and forcing ByteDance to divest their holdings. The Trump administration has promised to ban the app if it fails to divest its US operations by September 15^th 2020 so this complex deal has to be executed under immense time pressure.

Potential Strategic Benefits to Microsoft

1) Access to Data

The most obvious advantage to Microsoft would be the access to valuable consumer data that they could capitalize on. There are two main ways that the data can be utilized:

Data for Consumer Product Development

Microsoft’s success with consumer products has been abysmal even under the leadership of Satya Nadella. Some of the notable failed consumers plays include Windows Phone, Groove Music, Microsoft Fitness Band and Mixer Streaming Service. It has become increasingly apparent that Microsoft does not have the same level of understanding about its consumer business as it does with its enterprise business. The insights into consumer behavior gained through TikTok’s data could help to fuel research that leads to focused products that meet the consumer’s needs.

In addition to the data, Microsoft could learn from TikTok’s ability to appeal to and connect with a younger audience. The app’s UX as well as recommendation algorithm as well as video creation tools could be deployed into the existing and future Microsoft consumer-facing products.

Data for AI Development

The success of AI depends on the quality of information being fed into the models and the acquisition of TikTok will provide Microsoft with a rich dataset that will help to improve their AI capabilities. One of the challenges in AI development is finding labelled data that can be used in training models. With TikTok, Microsoft will now have a pre-categorized data set that has been tagged and labeled by the users.  The videos also provide an insight into the pop culture and Microsoft could feed the data into their training models and have an opportunity to create a highly sophisticated and realistic AI technology.

The purchase of TikTok will also provide Microsoft with a dedicated video platform which it lacked when compared with its AI rivals. Google has YouTube, Amazon has Twitch and Facebook has videos uploaded onto its platform as well as Instagram.

2) Capitalize on the Gen Z User Base

It is important to realize that Microsoft’s productivity tools are no longer as ubiquitous as they once were. With the advent of Google’s collaborative online tools, many children, especially from impoverished backgrounds who cannot afford Microsoft’s annual subscription, may never be introduced to Microsoft’s product range. Many schools have also started using Google Chromebooks in schools and they pair well with Google’s online productivity tools. Microsoft has a real threat of losing out on an entire generation of consumers.

By buying TikTok, Microsoft could gently introduce their productivity suite to this tech-savvy user base. Microsoft employed a similar strategy on their enterprise side by acquiring GitHub and introducing developers to their cloud computing tools.

Microsoft can also direct users from the app to their products. For example, TikTok could show game play videos and interested users could seamlessly be directed onto Xbox Live and begin playing the games themselves and sharing their experience and progress. Imagine new Xbox console or Surface laptop ads being displayed through native advertising. A direct pipeline can be created between TikTok and LinkedIn where professionals can provide career advice and the young users can be directly funneled into the professional network of LinkedIn and enhance the already strong network effects.

The acquisition of TikTok will provide Microsoft with a consumer runway that could guarantee its future viability and relevance if smartly capitalizes on the strong, engaged and young community that has been curated.

3) Boost Advertising Revenue

The digital advertising market is growing rapidly. In 2019, it grew by 19% as per eMarketer. While growth in 2020 will be weak due corporations cutting their advertising budgets, a strong recovery is expected in 2021 with a projected growth of 17%. 

Figure 1: Projected Outlook for Digital Ad Spending

Source: eMarketer

Microsoft has an ad business tied Bing and LinkedIn, which has plodded along in a disappointing single digit growth rate on a year on year basis and it is currently lagging significantly behind Google. Microsoft’s ad business only grew by 1% to US$ 7.7 billion but that growth was flat when excluding the fees it pays to partner websites and apps.

This year LinkedIn’s ad revenue has fallen as job advertisers have cut back on spending. On the other hand, Facebook and YouTube have seen their sales growth continue as users spend more time entertaining themselves online with a particular emphasis on video content. Without an entertainment service platform aimed at the broader market, Microsoft has struggled to capture the increasingly lucrative ads that videos flowing into YouTube, Facebook and more recently TikTok garner. 

Based on the data published by Apptopia, a startup that tracks app usage and revenue, TikTok made approximately $50 million in in-app revenue in the 4^th quarter of 2020. While the data published represents the entire global market for the app (including India where it was recently banned), Microsoft can still expect a sizeable chunk in ad revenue from it US, Canada, Australia and New Zealand operations and have a foothold into a market segment that is rapidly expanding. 

Figure 2: The strong growth of TikTok revenue in 2019, especially in the 4^th quarter.

Source: apptopia

TikTok is still at the nascent stage of monetizing their customer base. It has an estimated ARPU of $1 per quarter compared to US$ 33 by the mature Facebook (based on Trefis Research). TikTok demographic is also skewed towards teens and young adults and this could lead to more targeted niche ads. TikTok also has a much more engaged user base with the average user spending approximately 50 minutes on the app as opposed to 30-40 minutes on Facebook and Twitter. This all means that advertising revenue is primed to increase.

Figure 3: Quarterly ARPU per user across various social media platforms

Source: Trefis Research

A look at Microsoft’s revenue in detail highlights the need to revitalize their More Personal Computing segment as its share in total revenue has steadily declined from 44% in 2014 to 36% in 2019. The More Personal Computing segment consist of the entire Windows ecosystem, devices such as Surface and intelligent devices, gaming including Xbox hardware, software and social and finally search. The acquisition of TikTok could complement the existing products and improve the performance of this lagging segment.

 Figure 4: Revenue Breakdown of Microsoft by Business Segments

Source: Author’s calculations based on Microsoft’s 10-Ks. 

Potential Pitfalls for Microsoft

Despite the above-mentioned strategic benefits, I believe that this may not be the best acquisition for Microsoft.

 1. Geographical Fragmentation

 As mentioned earlier, based on the available information it appears that Microsoft will purchase the US, Canada, Australia and New Zealand operations of TikTok.

Removing and carving out these four regions from the main app will be a real challenge and this will mean that Microsoft will be left with an undersized platform that cannot really capitalize on the true potential of the network effects. This will severely limit their revenue generation and investment into the platform going forward.

While this split may make political sense, it does not make much business sense. Once the operations are divested, there will be two versions of the app available and these versions will need different servers, codes and teams to manage. This will be a massive undertaking for Microsoft as they need to recruit and build a team to manage. Moreover, in addition to the purchase price of TikTok further additional investment will be required to setup this localized version of the app. With the need to rebuild infrastructure, it is important to think about the return on investment. Any investment that Microsoft makes into the app will be spread across a smaller user base when compared to what it could have had with the global version. This makes investment inefficient and may discourage heavy investment into app development which in turn could stagnate growth.

In addition, with the ByteDance version of the app already being active across the world, there is a genuine question about how much room there is to scale the business further within the 4 markets. The only room for growth is to penetrate a different age group by acquiring and engaging older users. This may be harmful as the younger users may lose interest in the app and move away from it as they perceive the app to be uncool. This is similar to what happened with Facebook as younger users migrated out of the platform to other social media platforms leaving Facebook with a markedly older demographic.

The geographical fragmentation may also reduce the appeal for content creators within the platform. As mentioned in the previous blog post, the success of the app has been based around the propensity to go viral. With a severely restricted user base, the chance to go viral and reach a larger audience is severely limited. This may lead to influencers and content creators leaving the platform and moving to alternative platforms that still have a unified international audience.

Users may also leave the platform as the range of their content will become restricted. The international appeal that was vital to the app is now lost. With two versions of the app, there would be different trending videos and users may feel like they are being left out of the conversation.

Advertisers may also feel that their ad spend will lead to a lower reach compared to earlier. This may especially true for large multinational brands who covet international appeal. This would mean that advertisers may take a ‘wait and see’ approach and only begin advertising once the new app begins to settle down and the consumer behavior is carefully evaluated.

2. Demographic Fragmentation

While it is clear that social media will continue to be an integral part of the modern internet era, the landscape is increasingly becoming fragmented across different age groups. The older demographic seems to prefer Facebook while the younger generation is heavily involved in Instagram, Snapchat and TikTok.

There is also clear divide in user retention across the demographics. The older group prefers to stick to one platform and don’t migrate as often as the younger groups to other platforms. This could be due to fact that the older age groups are not digital natives and they would have invested their time in learning a particular platform. The younger audience on the other hand migrate frequently and it is becoming increasingly difficult to tie users down to a particular platform.

This could be a problem for Microsoft after the acquisition of TikTok. After the purchase, the users may be unhappy being in platform that is limited in content by geography and content creators may be unhappy with a limited audience and they may move to another platform that still has an international presence without any of the security concerns plaguing TikTok.

It is also important to highlight the downside risk of network effects. While network effects could lead to exponential growth in users after a critical threshold is crossed, if users begin to leave the platform the same network effects could bring the app crashing down. Once your friends and connections leave the app or become inactive, the social network does not bring much utility and users exit the network and find a growing and active user base.

 3) Increased Competition from Copycat Products

It is no surprise that the success of TikTok has spurned various copycat products that aim to capitalize on the popularity of the short video format and attempt to steal the market share away during this period of increased uncertainty.

The most prominent of the copycat products is Instagram Reels which attempts integrate the same short video-based format into their existing social media platform. Facebook employed the same strategy of copying a product feature when it duplicated the filter style from Snapchat after it turned down a takeover offer. While there is no question about Facebook’s ability to replicate and integrate new product features into their platform, the success of this strategy may not be as straightforward as earlier since the company is under intense scrutiny for its anti-competitive practices.

There are also other similar platforms that are launching with comparable functionality such as Triller.  The company saw exponential growth in July where the app was downloaded over 250 million times and reached No. 1 on the App Store. This growth was primarily driven from India where TikTok was banned.

4) Exposure to Regulatory Risk

 As mentioned earlier, Microsoft has minimized the high level of regulatory risk that has plagued various other Big Tech firms by focusing primarily on the B2B business and avoiding the fickle consumer business.

However, if Microsoft does acquire TikTok it could face a new host of regulatory challenges and come under increased scrutiny and it risks squandering the valuable political capital that it has diligently acquired over the past few years.

Even if TikTok’s data security issues are addressed, there are a host of other issues could cause problems in the future. The main issue will be data privacy and how Microsoft chooses to handle and use the data. Another issue that is unique to TikTok is the sensitive age-related content. Since TikTok’s client base is skewed young, there are a lot of parental concerns about the videos being uploaded. If TikTok cannot solve these issues, they could snowball into major problems into the near future. Age or content restrictions and censorship could harm the long-term viability of the company.

 Conclusion:

 Based on the analysis of Microsoft, it is clear why the company is interested in TikTok. The short-form video based social media platform appears to fill in various gaps within Microsoft and if properly handled this could be a successful acquisition. However, due to the political complexity of this transaction, the proposed partial acquisition of operations greatly limits the overall strategic advantages that Microsoft could gain from TikTok. If Microsoft could successfully navigate the fraught political issues plaguing the deal and if they manage to negotiate favorable terms, this acquisition could be yet another smart acquisition by Microsoft.