Google's Acquisition Of Motorola - Not Such A Failure After All

Feb. 2.14 | About: Alphabet Inc. (GOOG)

On Wednesday, Google (NASDAQ:GOOG) announced that it would sell Motorola Mobility's handset business to Lenovo for $2.91 billion. Google would keep all but around 2,000 of Motorola's 24,500 patents and pending patent applications, and this would end Google's long streak of operating losses at Motorola's handset division. I must admit that I am surprised at the $2.91 billion price tag, given that I originally thought Google would struggle to offload the handset business. But Lenovo's proven track record at managing an underperforming hardware business and its ambition to expand outside of the shrinking PC market makes Motorola far more valuable to Lenovo than it has been for Google. After all, Google's value of the handset business does not matter as much as Lenovo's value for the business.

When Google acquired Motorola Mobility for $12.5 billion in May 2012, most analysts believed that Google's main motive was to gain control of Motorola's 17,000 patents and 7,500 pending patent applications. At a headline figure of $12.5 billion, the cost that Google seemed prepared to pay for Motorola's patents seemed astonishingly high.

Even Nortel Networks' 6,000 patents and patent applications seemed overpriced, when the 'Rockstar' consortium, which includes Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), RIM (NASDAQ:BBRY), Sony (NYSE:SNE) and others, acquired them for $4.5 billion in 2011. Google and Intel (NASDAQ:INTC) had too tried to bid for Nortel's patent, following Nortel's bankruptcy; but, ultimately lost out to the consortium after bidding too low. Google's failure to win the patents may continue to haunt the company, as Rockstar has recently sued Google and smartphone manufacturers (many of them use Google's Android platform) over the infringement on the Nortel patents.

At a cost of $12.5 billion, Google did not only pay for Motorola's patents, but also its mobile handset and set-top box business. In addition, Motorola Mobility had a $2.9 billion cash pile and $2.4 billion in tax assets. Google has done a surprisingly very good job at striping the various different assets of Motorola. It sold the company's set-top box business to Arris Group for $2.35 billion and its handset division for $2.91 billion. Although the extent to which Motorola's deferred tax assets can be utilized by Google is unknown, Google does seem to be proficient when it comes to its tax affairs. Even without taking into account of the deferred tax assets, Google has reduced the cost it has spent on gaining control of Motorola's patents to less than $4.4 billion. Add back the cost of Motorola's operating losses of about $2.4 billion, the patents may have cost Google around $6.0 billion before taking into account of the deferred tax assets.

The rationale for keeping Motorola's mobile division as a standalone business has for sometime appeared somewhat unusual, as Google already has its own product line of Nexus smartphones and tablets. Also, Google's in-house engineers have been stretching their ambition by designing the Chromebook Pixel in-house. Google's desire to hinder Samsung (OTC:SSNLF) and Amazon's (NASDAQ:AMZN) growth in market share, and to prevent them from renegotiating the terms for revenue sharing of the advertising and Play Store sales, just did not seem to justify the cost of running Motorola's handset business on a standalone basis. Instead, it had lead to concerns that Google may show preferential treatment to Motorola at the detriment to other manufacturers who use the Android platform, and encouraged them to consider rival operating systems, including Microsoft's Windows Phone 8.

Motorola in Lenovo's hands could lead to a win-win situation for both Google and Lenovo. Lenovo is already the world's fourth most popular smartphone brand with a 4.9% market share in the fourth quarter of 2013. In China, its market share is even higher, at 11.8%. With Motorola, Lenovo can use the Motorola brand to penetrate markets it has so far been reluctant to do so with its own brand, including the Americas and Europe. The Motorola brand may also help it expand share in Asia and Africa. If Lenovo can maintain its strict cost discipline, and expand its smartphone market share in the same way it has done with PC sales, Lenovo can also help Android's penetration, particularly in emerging markets, and not only in China. Google has had little success in turning around the handset business. and a stronger Lenovo would seem to do more to keep Samsung and Amazon's kindle at bay, than Motorola as a standalone basis.

One drawback could be that Google may help turn Lenovo into the 'next' Samsung, and replace Samsung as the next dominant manufacturer. But this possibility seems somewhat remote. Although Lenovo has great ambition, and already has a strong brand in the PC market in both emerging and developed markets, it has yet to prove itself in designing software for smartphones that can compete in developed markets. Samsung already has a lot of success with its proprietary user interface, TouchWiz, and continues to invest heavily in software R&D, with about half of its R&D staff focusing on software development. Motorola with little success in stemming its decline in market share does not have very much to offer Lenovo. Furthermore, with Lenovo's shares in Hong Kong having fallen by 8.2% on the day of the announcement of its acquisition, market reaction indicates that Lenovo had overpaid for the handset business. This is despite the $2.91 billion deal consisting of only $660 million in cash, with $750m in stock and the remaining $1.5 billion paid in the form of a three-year promissory note.

By contrast, Google's shares have continued to rally following the announcement, and despite the company missing analysts' expectations for EPS to be $12.20. On Thursday evening, Google reported fourth quarter adjusted EPS of $12.01. Revenue per click had fallen by 11% for the fourth quarter, but that had been offset by a 31% rise in the number of paid clicks. Thus, Google's share price reaction has not only been a result of the sale of the handset division, but also because of the company's strong revenue growth in online advertising. With Google trading at almost 27 times 2013 earnings, investors can finally take comfort that Motorola's handset business would not continue to drag down Google's profitability for much longer. Now, all Google must do is show that its online advertising business will continue to expand at double-digit growth rates.

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.