Google’s Margins At Risk With Mobile Push From Motorola Deal

Google (NASDAQ:GOOG) has received the final approval for its proposed Motorola Mobility (NYSE:MMI) acquisition from the Chinese authorities after months of intense speculation that the country could block the deal altogether. China has however extracted a promise from Google that Android would remain completely open-source for the next five years at least. ^[1] Google has already received approvals from the U.S., Europe and Israel, and will be looking to close the deal this week itself.

The news alleviates investor concerns that the deal may face significant roadblocks in China considering the rather unpleasant past relationship between Google and China. (see Why Investor Concerns on the Googlorola Deal Falling Apart Are Premature)

The acquisition plans were made public in August last year when the two companies announced that they have come to an agreement under which Google would buy out Motorola Mobility for $12.5 billion in cash. Google has maintained that the acquisition was made with Motorola’s strong patent portfolio in mind as it would help it better defend its Android mobile platform from lawsuits filed by Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT).

However, we believe that Google has bigger plans in mind. While the addition of more than 17,000 Motorola patents will no doubt strengthen Google’s patent  portfolio, we believe that the 63% premium that Google has paid for Motorola’s rather under-performing mobile business needs a bigger justification in the form of a grander mobile hardware play.

See our complete analysis for Motorola stock here

Google eyes growing mobile search market

Google already is a dominant player in the online search business for desktops and notebooks. However, as PC growth slows and more users adopt smartphones to stay connected on the move, an increasing number of Internet searches will be performed on mobile phones and online ad dollars will shift to mobile advertising.

Coming up with an open mobile platform, the Android OS, was Google’s way of entering the smartphone market. Now, armed with Motorola’s hardware business, Google may plan to come out with a good enough smartphone at cheaper price points to milk the demand for Android smartphones and further increase its presence in the growing mobile search market. (see Are Cheap Google-Motorola Smartphones on the Way?)

Margins to decline

While such a move may lead Google to take a hit on its margins, it may be worthwhile as it can help drive mobile ad revenues in the long run. This strategy is not very different from Amazon’s plan to sell the Kindle Fire at a very low price point in order to drive its core content distribution business and compete with Apple. Or Verizon, AT&T and other such telecom providers’ approach to drive data consumption by subsidizing smartphones.

However, similar to the margin hit that the carriers have suffered as a result of the smartphone boom, this will deepen the margin loss that Google will be suffering by acquiring Motorola’s business. We estimate that Motorola Mobility will generate $13.1 billion in revenues and only 64 million in operating profits in 2012. This will significantly dent Google’s overall operating margins (adjusted for operating leases) to about 27% from ~35% pre-acquisition.

Apart from the margin concerns, Google also runs the risk of alienating existing Android partners who may start seeking ways of lowering their dependence on the Android platform thus posing a direct threat to Google’s mobile search ambitions. However, with Google’s commitment to China that it will keep the Android source open to all for the next five years at least, these concerns have been alleviated for the time being.

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1. China adds conditions to approval of Google bid to buy Motorola Mobility, Guardian, May 21st, 2012 [↩]