Is Google Making Motorola A Loss Leader?

Dec. 4.13 | About: Alphabet Inc. (GOOG)

Google (NASDAQ:GOOG) has captured more than 80% of the smartphone OS market and has become the No.1 player in the tablet OS market as well. By giving Android for free, Google has become the dominant OS company in the computing market. Microsoft (NASDAQ:MSFT) had long ruled as the monopoly OS supplier to the computing market and even now has more than 90% market share in the PC OS market. However, the rapid growth in smartphones and tablets in the last 5 years has meant that Google has beaten Microsoft using its "free" strategy.

Apple (NASDAQ:AAPL) has also become a powerful player in the OS space with iPhones and iPads dominating the premium end of the market. However Apple has failed to introduce products for the middle and lower segments of the market, leading to a lowering in the market share. Google is not resting on its laurels but continues to invest in making Android more pervasive. Google has very cleverly used its Motorola acquisition to make further inroads into the smartphone market. It is clear from Google's actions that the company wants to make Motorola a loss leader which will lead to penetration of its Android OS with its inbuilt Google services.

Google's strategy in selling smartphones is very different from that of Apple. The company wants to make money through the sales of its web services rather than through the sale of hardware or OS. While companies such as Samsung (OTC:SSNLF), Lenovo (OTCPK:LNVGF) etc. have already made Android widely accepted, Google is further expanding Android's penetration by selling high quality Motorola smartphones at extremely low prices (and margins). I remain positive on Google given the company's substantial moat in the Internet search segment and rapid expansion of its map, video, email and other web services.

What is a Loss Leader

One use of a loss leader is to draw customers into a store where they are likely to buy other goods. The vendor expects that the typical customer will purchase other items at the same time as the loss leader and that the profit made on these items will be such that an overall profit is generated for the vendor.

"Loss lead" describes the concept that an item is offered for sale at a reduced price and is intended to "lead" to the subsequent sale of other items, the sales of which will be made in greater numbers, or greater profits, or both. It is offered at a price below its minimum profit margin-not necessarily below cost. The firm tries to maintain a current analysis of its accounts for both the loss lead and the associated items, so it can monitor how well the scheme is doing, as quickly as possible, thereby never suffering an overall net loss.

Source - Wikipedia

Android has increased its already large marketshare

It has been quite remarkable on how Google has managed to keep its Internet search market share so high (near 70%) despite facing powerful competition from the likes of Microsoft and Yahoo (NASDAQ:YHOO). Yahoo has given up on search using Microsoft's technology to cut losses while Microsoft itself may be toying with the idea to sell Bing. Even as other companies' strong areas come under competitive attack, Google's search dominance looks almost non-defeatable. The company has smartly used the billions of dollars being generated from its search business to become the dominant Internet company.

Google has made itself the No.1 player in a number of fast growing Internet segments such as mapping, video, email etc. by successfully copying Microsoft's "free" strategy. The company gives all its products for free earning money through advertising and by selling premium services to businesses. This strategy was necessary as Microsoft dominated the computing industry through its Windows operating system. With the rapid growth of mobile computing (thanks to Apple's iPhones and iPads), Google latched on early to the mobile trend by giving Android for free. This allowed the company to get access to hundreds of millions of smartphone users.

Microsoft only woke up to the mobile threat in the last couple of years and is spending billions to remain relevant [Nokia (NYSE:NOK), Surface etc.]. Google has also managed to increase Android's market share to more than 80% in the smartphone market, going up from an already high 70%. With its strong ecosystem, it will be difficult for other operating systems to steal market share from Google now. Apple's iOS remains a good competitor but Apple's reluctance to play in the mid and low end of the market has made Google's job easier.

Top Four Operating Systems, Shipments, and Market Share, Q3 2013 (Units in Millions)

Operating System

3Q13 Shipment Volumes

3Q13 Market Share

3Q12 Shipment Volumes

3Q12 Market Share

Year-Over-Year Change

Android

211.6

81.0%

139.9

74.9%

51.3%

iOS

33.8

12.9%

26.9

14.4%

25.6%

Windows Phone

9.5

3.6%

3.7

2.0%

156.0%

BlackBerry (NASDAQ:BBRY)

4.5

1.7%

7.7

4.1%

-41.6%

Others

1.7

0.6%

8.4

4.5%

-80.1%

Total

261.1

100.0%

186.7

100.0%

39.9%

Click to enlarge

Source - IDC

Google using Motorola to further entrench Android

Google came under criticism for buying Motorola as the company was not being able to turnaround Motorola's continuous losses. These operating losses were a drag on the company's earnings, but Google's management seems to have a specific use for Motorola. The company does not want to become a top hardware vendor but use Motorola to introduce top Android devices at extremely low prices. This will not make big profits for Google but further entrench Android in the smartphone market. Motorola did not introduce a lot of products in the last year as Google needed time to integrate it. Moto X was the first product to be designed and produced after Google acquired Motorola. Google wants Motorola to introduce cutting edge smartphones at low prices which would hurt both Apple and Microsoft.

I think that Microsoft has a lot to lose, as PC sales continue to decline. Microsoft will make less money each year from OS and Office Sales as PC sales decline. Its smartphone OS market share is miniscule (3.7%) and it has to sell the smartphones at a very low price, which means it gets low margins on Windows sales to mobile devices. Apple has managed to earn high margins by selling mobile devices only in the premium segment. But with Google selling top end devices such as Nexus 5 for almost half the price of an iPhone5S, I think that Apple will not be able to sustain the high prices. The company's overall margins will keep falling as it has to lower prices to fight Google.

Moto G indicates Google's intentions of commoditizing Mobile Hardware

The Moto X was priced a bit too high in my view, compared to the hardware specifications and features. It was a surprise given how competitive the Nexus products are in terms of pricing. I think that Nexus 5 is the only top end smartphone which can be bought at a mid end price (I am excluding the Tier 2 vendors such as Xiamo and Micromax). People are starting to realize the tremendous value that Nexus products offer, with Nexus products frequently getting sold out. While Nexus was being manufactured by non-Motorola companies, the new Moto products are complete Google products. The Moto G is Motorola's first major low end smartphone product launch under Google. The company is using the same strategy of selling through its online store without contract. This helps Google circumvent telecom carriers and sell directly to end users.

Moto G's $179 price is extremely competitive for the hardware specifications and I expect that this product will be as popular as the Nexus products. The price of Moto G is similar to the prices of low end Android companies such as Lava, Coolpad etc. but you get the branding and status symbol of owning a Google product. This makes a big difference especially in emerging markets where status is very important. I think that Moto G offers great value at this price; and it will pressure both Microsoft and Apple (even Samsung). Moto G will also force all Android players to further improve their quality and lower prices as Moto G comes with the latest Kit Kat version. I don't think Google wants to decimate its Android partners by making Motorola a big competitive threat. It wants to keep the pressure on Android companies to keep improving their products. Microsoft tried something like that with Surface but failed.

What could go wrong

i) Microsoft's Nokia Buy - Microsoft has realized that it could become a non-existent player in the computing OS market as Android and iOS keep gaining marketshare every year. The company has thrown a lot of resources at both mobile hardware and software to become a substantial player in the mobile market. However, the company's early efforts have not yielded much fruit (Surface, Windows 8). Microsoft knows that it cannot accept defeat and will keep throwing billions of dollars to become a bigger mobile OS player. Its Wintel partner Intel (NASDAQ:INTC) is also working hard to capture a greater share of the mobile processor market. These companies also have introduced innovations such as tablet-laptop convertibles.

ii) Samsung's Smartphone Dominance - Samsung has become the most influential mobile hardware vendor at par with Apple. The company is currently in the Android camp but the company is looking to increase its influence of mobile software and services. The company has already launched its own mobile OS Tizen, but has been a bit slow in introducing Tizen products. Samsung is the only large profitable mobile hardware vendor besides Apple and it is the biggest smartphone shipper in the world. Google has to be careful on how it works with Samsung both as a competitor and a partner. If Samsung finds that Android is becoming a threat or that switching to an alternate OS is feasible, then it could deal a big body blow to Google.

Stock Price and Valuation

Google is making new all time highs in 2013 as its stock price has crossed the four digit mark. The company's stock has been the best performer amongst large technology companies such as Cisco (NASDAQ:CSCO), Intel etc. Google has seen a spectacular run over the last one year gaining almost ~50% compared to NASDAQ, which has increased by just ~30%. Google trades at a forward P/E of ~21x, which is a premium compared to other technology peers due to its higher growth rate and competitive positioning.

GOOG Total Return Price Chart
(Click to enlarge)

GOOG Total Return Price data by YCharts

Summary

Google has managed to remain highly innovative despite its large size as the company keeps introducing unique new products/services. Many of the company's products such as Google Maps and Youtube have become ubiquitous. Google Search remains totally dominant despite Microsoft pouring billions of dollars to make Bing a viable competitor. The company is smartly using its Search revenues to get into newer areas such as wearable computing and further consolidating its lead in areas such as mobile operating systems. The company is now using Motorola to increase the bar on smartphones and put pressure on its main competitors. Google's management always seems on the ball unlike Microsoft and Apple. I would look to buy Google on pullbacks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.