Google's (GOOG) earnings debacle last week is the latest in a series of misfortunes that has befallen the giant Mountain View technology behemoth in the last few months. The company has been making less and less money from its online ad sales, and is yet to gain a serious stronghold in the mobile ad sales space. While it has made its Android OS more and more competitive vis-a-vis Apple (AAPL) iOS, which I discussed in another article, it is still to make enough money from selling ads via the Android media. It is embroiled in multiple patent lawsuits, some of which are not looking too well from Google's perspective, and to top it all, the FTC is investigating Google for anti-trust issues.
Make no mistake, this author has long held a strong opinion that Google has done more than almost any other company in ushering in the modern Internet age; an age that has freed up latent talent in millions of people and businesses around the world. Google's direct contribution to opening up a multi-trillion dollar business arena is immense. With all its imperfections and numerous detractors, today's world can really be divided into two time periods - before Google and after Google.
However, be that as it may, what we as investors need to consider is whether the recently brewing troubles are temporary in nature, or is this a vanguard of something worse to come for the company. So let me take a quick look at some of the issues facing Google, and see if we can figure out what our perspective should be as to the nature, longevity, and outcome of these troubles.
Lawsuit By Vringo
It all began with these two patents filed by Andrew Kennedy Lang, Ken Lang for short, now the CTO of Vringo, formerly the CTO of Lycos, to whom he sold rights to his patents back in 1998 and then repurchased them recently: Patents 6,314,420 and 6,775,664 (ironically, I found the text of these in Google Patents).
Patent 6314420 is titled "Collaborative/adaptive search engine" and its summary is here:
A search engine system is provided for a portal site on the internet. The search engine system employs a regular search engine to make one-shot or demand searches for information entities which provide at least threshold matches to user queries. The search engine system also employs a collaborative/content-based filter to make continuing searches for information entities which match existing wire queries and are ranked and stored over time in user-accessible, system wires corresponding to the respective queries. A user feedback system provides collaborative feedback data for integration with content profile data in the operation of the collaborative/content-based filter. A query processor determines whether a demand search or a wire search is made for an input query.
Patent 6,775,664 is called "Information filter system and method for integrated content-based and ..." and its summary is just the same as the one above.
These patents are vitally important to something that makes Google almost all its money - Adsense and Adwords. Let me quote from the original Vringo complaint:
In the search engine industry, results are positioned on websites based on their determined "rank." For example, in search advertising, an advertisement with the highest "rank" appears in the first position, and so on down the page. Search engines seek to place the high quality advertisements in the best positions because such placements are critical to attracting advertisers, pleasing end users and producing search advertising revenues (the primary source of revenue for search engines). Andrew K. Lang and Donald M. Kosak, inventors of U.S. Patent Nos. 6,314,420 ("the '420 patent") and 6,775,664 ("the '664 patent") (collectively "the patents-in-suit"), invented a relevance filtering technology that is used in the search engine industry, and that has become the dominant technology used to place high quality advertisements in the best positions and thereby generate substantial revenue. At least some of the defendants knew about the patents-in-suit for years, and despite such knowledge, these defendants continued to use it unlawfully. This patent infringement action seeks a remedy for this unlawful taking.
There is hardly any issue in my mind here that Vringo is right and Google has used this patent for years. If you read any version (for example, Google's own article here) of Google's Adwords Quality Score and ranking algorithm, you will see how similar the concepts are. Judge Jackson has turned down the issue of willful infringement mainly because Vringo did not wish to pursue it. While that may be a smart decision given that they are claiming a 3.5% loyalty already, I do think that the infringement was pretty willful. I am sure Google is going to lose this case or settle, at least on major issues, and Vringo is going to make a good deal of money out of it. I am still somewhat puzzled by the reasoning behind Google's decision to take this to trial. They could have tried to just buy off or buy out Vringo and be done with it. If they thought they would teach the small ugly troll a lesson, I think this is a step that may backfire.
Microsoft (MSFT) Patent Infringement Case
Microsoft has been fighting an ongoing war against Motorola Mobility (acquired earlier this year by Google for $12.5 billion) and it has already won two battles for patents dealing with software keyboards and file indexing technology that saw an injunction to ban Motorola phones being granted. In its recent onslaught, it has filed for infringement in the case of patent EP0845124B1 on a "computer system for identifying local resources and method therefore." that relates to acquiring data about local resources that Motorola uses in Google Maps. Apparently Motorola has rolled the ball into Google's court by claiming "it lacks sufficient information about actions occurring on Google's servers." This has led to Microsoft saying it will amend its complaint to include Google. The trial date is set for March 7th, and this will be the first time Google and Microsoft will be in a courtroom facing each other over a patent infringement issue.
Compared to the Vringo case, this is a regular small fry because although if Google loses the case it will have to pay some damages (or settle before trial), the free Google Maps app is nothing compared to Adsense in terms of revenue, where it reported $11.52 billion, or 82% of consolidated revenues, this quarter. So royalty related damages will not be comparably high here.
EU Privacy Issue and France News Content
Finally, The Earnings Debacle
If you check Google's latest SEC filing (press release) you will notice this strange sentence I have marked below.
The story is that these results were accidentally released by printers R.R. Donnelly and Co (RRD) before Google was able to add comments from Larry Page. I am guessing those would have been an effort to put a positive spin on an otherwise dismal result. Google, it must be remembered, beat street estimates in both of the previous two quarters by a decent margin. This time around, it missed estimates by a whopping 15%, with an EPS of only $9.03 against estimates of $10.65. Motorola Mobility, its latest large acquisition, was a big loss for the company:
Motorola Operating Loss - GAAP operating loss for Motorola was $527 million ($505 million for the mobile segment and $22 million for the home segment), or -20% of Motorola revenues in the third quarter of 2012. Non-GAAP operating loss for Motorola in the third quarter of 2012 was $151 million, or -6% of Motorola revenues.
Source: SEC press release cited above
The results were so bad that its stock tumbled and it was forced to close trading for 2 and half hours. According to a Bloomberg report quoted here:
Google traded at an average price of $704.43 from when its results were released at 12:30 p.m. in New York and the time of the halt at about 12:51 p.m. That's down 6.4 percent from the average level of $752.99 prior to the news, data compiled by Bloomberg show. The shares closed at $695 about 40 minutes after being resumed.
On top of this all, there's recent news that the FTC is planning to bring anti-trust actions against Google as recently as next month.
Patent lawsuits are nothing new for Google. An uncountable numbers of these suits are filed by or against Google every year; you win some, you lose some - for those you lose, you file away legal expenses for them in your quarterly filings and save some taxes. This is the business, everyone knows it, and while potentially Microsoft's lawsuit against Motorola could have created major issues for Android, I don't think Microsoft aims to do that right now. Google is relatively safe here - Microsoft does not make most of its money from patent infringement damages, nor does its survival depend on winning this lawsuit.
Vringo's does. This is a patent litigation company that is going to become a microscopic stock - if it exists after losing the lawsuit to Google. This lawsuit, if won, will alone ensure over $30 million in annual revenue for Vringo for years to come. Everything that we see in Vringo's stock today is formed from investor expectations that it will win. Therefore this is an all-out war for survival for Vringo and Google should pay the highest attention to this one.
Vringo has a stellar legal team headed by David Cohen who has the distinction of winning a $700 million patent suit against Apple, and Donald Stout who has won a $600 million settlement against Research in Motion (RIMM). I have discussed the depth and strength of their team in another article. While writing that article, I thought there was a very big chance Google would lose this case if it proceeded to trial, given that there was/is a pronounced perception that Google did indeed infringe. So I thought Google should see this through until the start of trial and then settle -- or probably settle before it lost too many important motions.
If it doesn't settle, though, the fallout could be ugly. This lawsuit is not about Google Maps or some other less financially important component of Google's business. This is about Adwords and Adsense, the primary revenue earners in Google's portfolio. If it loses the case, it will potentially open itself up to multiple other lawsuits in this area, and it really cannot afford to pay a lot of royalty percentages from this particular business.
As for the EU and the FTC, at present, these are like so many jokes compared to Vringo's big play. However, the problem with these governmental allegations and investigations is that these things have a tendency to stack up. If they form a large enough stack of complaints, over time, such a stack of problems has a tendency to fall down - hard - on top of the company being pursued by the governments for whatever reasons. Google should attempt a divisive policy - placate someone, play hardball with another - but never let everyone get angry at the same time.
As for us investors and market watchers, this is not a good time to open new long positions on Google trading as it is at $681 at last read. This stock is going to move up/down with the Vringo lawsuit, and we should keep a steady watch on what is going on as the trial progresses.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.