Google (NASDAQ:GOOG) recently announced that it completed the acquisition of Motorola Mobility (NYSE:MMI) for $12.5 billion. The deal was not easy. It took Google significant effort to obtain regulatory approvals without conditions. The marriage of an internet company to a hardware company is often complicated.
Investors are wondering how an internet giant like Google can integrate with and run a hardware company that has been bleeding cash over the last few quarters. A quick answer is that Google can manufacture hardware in large quantities. Recall that Motorola was once a major mobile manufacturer. Its Motorola Razr model sold more than 100 million units. Looking at OEM market share data, Motorola holds a market share of 13.7%. This is down from the previous year's share of 20%. The company later decided to manufacture phones on the Android platform, which saw strong market reception based on its reviews. Therefore, Motorola has a fighting chance to move up the ranks in the smartphone space.
The Motorola acquisition equates to a third of Google's cash balance. Google recently reported an $86 million net loss for the first quarter, slightly higher than its loss for the same period last year. Total handset shipments declined from 9.3 million units to 8.9 million units. The silver lining is that smartphone shipments increased to 5.1 million from last year's 4.1 million units. Clearly, Google sees continued high potential in the smartphone market.
Patent is just one of those investment merits of Motorola's acquisition
The acquisition of Motorola solidifies Google's position in the midst of its intellectual property battles. Google added 24,500 patents to its growing portfolio. Meanwhile, Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL) are joining forces to attack the Android patents. Apple has accused Samsung of stealing its intellectual property with the release of Galaxy Tab. Apple successfully blocked off Samsung from promoting its new tablet. This results in lost marketing efforts, as well as bigger opportunity costs. Additionally, Samsung would have to think twice about starting campaigns in different countries that have strong patent and implementation laws.
On the other side, this also strengthens the position of Android as a mobile platform. The platform was in 56.1% of all smartphones sold in the first quarter this year. It beats Apple's iOS, which represents 36.4% of the worldwide smartphone market. Nokia's (NYSE:NOK) Symbian operating system has a market share of 27%. Meanwhile, Research In Motion's (RIMM) market share has declined to a mere 13%.
The laggard is Microsoft, which corners only 2.6% of the worldwide smartphone market. This trend will likely continue in the near future as Android holds a strong competitive position in the Asia Pacific phone market.
Google has stated in a press release that Motorola will stand as a separate business. This addresses concerns that it will no longer remain as an open source mobile platform. There are reports that Samsung and HTC were nervous about the deal. In fact, Motorola will remain a licensee of the Android platform. I believe that Google will be spending more time developing better Motorola models to suit the changing Android ecosystem. It is about innovation, rather than a defensive move on Google's part to acquire Motorola.
Despite the assurance from Google about Android, there are still risks that it could alienate other smartphone makers. In turn, these smartphone makers would seek ways to minimize their independence on the Android platform. This poses risks of the original plan to pursue the mobile search space via Android.
Margins will decline for the sake of future growth
The move to buy Motorola will have an impact on the margins. Major phone manufacturers have slim margins. The cost to produce a smartphone ranges from $150 to $200 per unit. Conversely, for market leaders like Apple and Samsung, they could easily maintain a margin of 40% to 50%. The challengers are forced to subsidize a portion of the cost to attract new clients to switch to their phones. I expect margins to be slim for Motorola going forward.
This is not a point to be overly concerned about, however. Google has maintained net profit margins of 25% over the last five years. A conservative assumption would be a 100 to 150 basis point impact on profitability. This appears to be insignificant relative to the benefit it will give Google over the long run.
At present, Google is trading at 13 times 2012 earnings. This is lower than its five-year average earnings multiple of 19 times. The stock trades at 10 times earnings. These valuations do not justify the economic prospects of Google and its dominance in the market it operates. In fact, the market is discounting slight earnings growth in the future.
In contrast, Apple trades at 12 times earnings. It is in a position similar to that of Google. The market is discounting slower growth in the coming years. Other peers, like Baidu (NASDAQ:BIDU), trade at 36 times earnings. Yahoo! (NASDAQ:YHOO) trades at 17 times earnings. These companies trail to Google, yet the market has valued them higher.
It is too early to say that this acquisition will produce handsome returns for Google. Google's track record on acquisitions has been relatively good. Double Click, an online advertising firm that Google bought for $3.1 billion, is currently generating $2 billion a year. Likewise, YouTube, the popular video sharing website, was bought for $1.65 billion, and generates $1 billion annually.
The Motorola acquisition will have a big impact in the coming years. It is safe to assume that Google has gone all in on this deal, and I believe in Larry Page's capital allocation skills.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.