The Cost Of Google's Acquisition Of Motorola Continues To Mount

| About: Alphabet, Inc. (GOOG)
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On Tuesday, Google's (NASDAQ:GOOG) Motorola announced that it will sell its flagship Moto X smartphone in the UK, France and Germany by February this year. It hopes the smartphone would be more popular in Europe than it has been the US, as European customers are much more likely to purchase smartphones without a wireless contract, which generally makes them more cost conscious. Earlier this month, Motorola cut the price of its Moto X smartphone for US customers without a wireless contract to $399 from $550 previously. Whilst some observers see this as Google's attempt to commoditize the mobile hardware market, it appears to be much more of a forewarning that the smartphone has not been selling as well as the company initially expected.

When Google acquired Motorola Mobility for $12.5 billion in May 2012, the main prize from the acquisition has been to gain control of Motorola's 17,000 patents and 7,500 pending patent applications. These patents have been supposed to help Google fend off litigation against its Android operating system from the likes of Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Oracle (NYSE:ORCL).

Google has been able reduce the net amount it spent on Motorola's intellectual property by selling the company's set-top box business to Arris Group for $2.35 billion. Motorola's $2.9 billion cash pile and $2.4 billion in deferred tax assets has further reduced Google's net acquisition cost from the headline price tag of $12.5 billion. Nonetheless, in the first nine months of 2013, Motorola's mobile division generated an operating loss of $645 million, and there are very few signs that the losses are going to abate anytime soon. Although Google may have benefited from Motorola's large patent portfolio, the cost of its acquisition seems to be rising by the day.

With expectations of Google's operating cash flow for 2013 to be in excess of $18 billion and robust growth in advertising revenues, the market can afford to turn a blind eye to losses at Motorola's mobile division. But with Google trading at 26 times expected 2013 earnings, investors would most likely need to see some indications that Motorola would not continue to drag on Google's overall profitability, before rewarding the company's shares with even higher valuation multiples.

Analysts have often pointed to Google's desire to commoditize the mobile hardware market as one of the other reasons for acquiring Motorola Mobility. Samsung (OTC:SSNLF) may become increasingly keen to exploit its substantial market share within the Android smartphone market by renegotiating the terms for revenue sharing of the advertising and Play Store sales generated from its smartphones and tablets. Amazon (NASDAQ:AMZN) has opted for a customized version of Android which excludes Google's Play Store, so that customers would shop at its Amazon Appstore instead.

But, the rationale behind keeping Motorola's mobile division as a standalone business seems somewhat unusual, as Google has developed its own Google Nexus line of smartphones and tablets by cooperating with traditional manufacturers, including Samsung, HTC (OTC:HTCCY) and Asus (OTC:AKCPF). More recently, it has designed the Chromebook Pixel in-house, which shows that Google's in-house engineers could also develop mobile devices in the near future. It is also surprising that Google has yet to integrate its Chromebook OS for netbooks with its Android OS, in a similar way as Microsoft has done with its Windows 8. Chromebook's browser based operating system has been a key obstacle in preventing more consumers to adopt the product instead of a small laptop or tablet.

Motorola has not exactly had much success in containing the more dominant manufacturers, and Google has shown little interest in better integrating Motorola devices with its Android OS, in fear of showing too much preferential treatment and upsetting other handset manufacturers. Nonetheless, Google would find it hard to sell or spin-off Motorola's mobile device business without its patent portfolio; and so this can only mean that it will likely have to keep the business. However, with Motorola's weak branding, limited scale, narrow product breadth, and an unwillingness to better integrate its hardware with Google's software, Motorola's future as a standalone business seems uncertain. At some point, Google may need to (re)consider shutting down the business, or consolidating it within its own growing hardware division.

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.