Well, the numbers have been counted and the results are in. Google (NASDAQ:GOOG), reported its financial numbers for the first quarter of 2013, toppling analyst expectations once again with net revenue growing 23%. Google posted $9.99 billion in revenue as the company's search and advertising businesses continued to strengthen.
So what does Google do with all of its cash? While some investors want Google to start rewarding them with dividends, others prefer such things as stock buybacks or buying out its competitors. With no news of a dividend or a stock buyback program from its latest earnings report, Google at least put its cash to use when it purchased Motorola last year for $12.5 billion. This was Google's biggest acquisition ever, helping it transition from its search-and-software company to more of a consumer gadgets maker.
So why did Google decide to take the plunge and buy Motorola? Three words come to mind; patents, patents, patents. Acquiring Motorola gave Google access to more than 17,000 patents, with an extra 7,500 that are still awaiting approval. Google said that it plans to use those patents to fend off lawsuits from companies like Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Vringo (NASDAQ:VRNG), which threaten the demise of Google.
Vringo, which has an ongoing patent infringement case against Google, was awarded $30.5 million in past damages last November. The jury unanimously found Vringo's "420 Patent" and "664 Patent" to be valid and Google liable for its infringement on Vringo's patents relating to the search engine and information filtering process. Vringo was also awarded, along with past damages, with a running royalty rate of 3.5% through the first quarter 2016 when its patents expire. So how much does that all come out to? Let's take a look.
Google's $200 Billion Dollar Decision
Looking over Google's earnings report Thursday, April 18, we can see how strong Google's financials are, with consolidated revenue reaching over $13 billion last quarter. Let's also not forget that Google has over $50 billion in cash. As we can see, Google certainly isn't hurting for cash. So is Google's revenue dominance going to continue? While nobody can predict the future, going off of Google's past growth rates, Google could see total ad revenues climb upwards of $194 billion through the first quarter of 2016. The table below breaks down Google's revenue year by year.
$50 Billion +
$58 Billion +
$67 Billion +
As we can see, Google is on track to make $194 billion dollars in revenue through the first quarter of 2016. If we divide that by Vringo's 3.5% royalty rate we can see that Vringo would receive around $635 million in royalties over the next four years. On a per quarter basis for Vringo that would come out to roughly $40 million per quarter.
Could Google Work Around The Patents?
Yes, this would be a major blow to Vringo. The patents that Google currently uses from Vringo are bringing in billions of dollars of ad revenue for Google. If Google works around them then Vringo would miss out on hundreds of million of dollars in royalty fees. Vringo would still collect past damages ($30.5 million), but royalty fees is where it's at.
I often ask myself why would Google go through such a big process just to save a couple million bucks especially when it's already making billions of dollars off of the patents? Also, if it was so easy to work around the patents now, then why hasn't Google already done so? Why would the company drag out the trial (paying litigation fees) as it has been doing? This is why it doesn't make sense, in my opinion, that Google would work around the patents. However, weirder things have happened in the case between these two companies, so investors shouldn't be surprised if something like this does end up happening.
Google's Workaround Theory
Statement from defendants (Google) filed April 16, 2013.
Ex. 1.) Defendants informed Plaintiff that Google will be launching a change in the operation of AdWords that would remove the functionality that Plaintiff has pointed to for infringement of the filtering step, and would not infringe under Plaintiff's theories. Defendants offered to provide discovery into this functionality in order to avoid wasteful, additional motion practice. (Id.)
So is this just another one of Google's bluffs and scare tactics that Vringo investors have seen plenty of times before? Unfortunately nobody knows this but Google themselves. If indeed Google is telling the truth about possessing a workaround, then Vringo would be left without future royalties and subsequently a vastly diminished revenue base. If anyone in the world possesses the software technology capable of working around patents, it would be Google. Since the beginning, Google has made it known that non-practicing entity's (NPE's) or "patent trolls" which some people like to call them, are to blame for the things wrong within the patent system.
Is The Workaround Worth It?
Vringo still has over three years left remaining on its patents. That seems like a lot of time for many investors, but in the world of patents and workarounds, that's not very much time. Think about that in the examples below:
Risk: Imagine yourself as one of the biggest shareholders of Google's stock. I assume that because you have such a large position in Google that you have done your due diligence and know Google inside and out. What would your reaction be if you found out that Google worked around Vringo's patents? Your initial reaction would probably be excitement in that Google won't be shelling out hundreds of million of dollars in royalty fees. However, after all the excitement, reality sets back in. Changes are changes. That means that Google's services will be different right? How will the "new changes" be accepted by advertisers and the consumers? Will it be more effective or will the new system be an epic fail? Just look at what happened to Netflix (NASDAQ:NFLX) just a couple of years ago:
The Netflix Effect: Netflix has been one of the markets' darlings as well as the most hated stock in the market. If investors thought Vringo took investors on a roller coaster ride the last six months, then what would that make Netflix shareholders? Over the last two years Netflix has been all over the place jumping as high as $300 only to fall all the way down to the $50 range. Now the stock is currently trading in the $163 range. So what caused all the chaos?
Netflix Splits up its services
The price adjustment, announced July 12, 2011, made Netflix's DVD-by-mail service, which was a two dollar add-on to its eight dollars a month streaming service, and made it a separate eight dollar package. Netflix's online streaming service remains at eight dollars but the DVD-by-mail service is also at eight dollars. Customers were outraged by the 60% price increase for the combined services and the stock price showed it losing more than 75% of its value. Does Google want something like this on its hands? For the sake of Google's shareholders, I would hope not.
Testing The Workaround: We've all seen how long it takes for products to be tested before they come out on the market. This is especially true for pharmaceutical companies, which usually takes even longer for them.
So the first step in the process is for companies to engage in the development process. The next stage or process is testing, and lots of it. Companies must be sure that the product meets the requirements guided by its design and development. It has to make sure that it works as expected, can be implemented with the same characteristics and satisfies the needs of stakeholders. If any issues come up (which usually happens), they have to be fixed and tested repeatedly until the product is ready to be launched. So with three years remaining until the patents expire, will Google go through this process just to save a couple hundred million to change a system which is generating hundreds of billions of dollars for it? It would be a foolish move, in my opinion, if Google did.
If you had a business, would you allow a significant change to take place in that you risk your source of $50-60 billion a year of revenues to save a measly $635 million in royalty fees over 3 years? What happens if the new change is not well received by advertisers and customers? What if Google's quest to save $635 million ends up causing Google to lose market share to its competitors. The uncertainty of making such a significant change to save $635 million could bring Google to its knees. Would Google want to risk the new change by introducing a new mediocre product?
How will the markets react to the change? Many investors look at different areas to determine what the proper value shares in the market should be worth. Some of these areas include; Earnings [EPS], Cash Flow, Price-Earnings Ratio [P/E], Book Value, Cash Per Share, Price Targets etc. The new change could alter everything that is baked into Google's stock price right now.
So my message to Google is simple. Losing money is never fun. However, by changing your product you are already admitting defeat to Vringo. You are proving that Vringo's patents are valid and enforceable. Remember in court when under oath you said your products did not infringe on Vringo's patents. Well, answer me this then: How come you're "changing" your product now so that it does not infringe under Vringo's patents, as you state in the motion on April 16, 2013? By changing your system, which is on track to bring in over $200 billion in revenue by the way, you are simply saying that Vringo is worth more than that. Not bad for a small company in Vringo that has a market cap currently worth only $237 million. I'd advise you to be wary Google, because Microsoft is waiting in the wings and is already in talks with Vringo. So don't make a mistake that you'll be regretting later.
Investors are reminded that Google has deep pockets (over $50 billion in cash) so the company could have already easily settled with Vringo by now. Because it didn't choose to do so, Google is sending the message that it will not stand idly by and settle with whoever (patents trolls) wants to sue it.
Disclosure: I am long VRNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: Investors are always reminded that before making any investment, you should do your own proper diligence on any stock mentioned in this article. Any material in this article should be considered general information, and not relied on as a formal investment recommendation. I hope this article was helpful to you and I look forward to all of your comments and insight.