Still Many Questions About Google's Motorola Deal

The market consensus seems to be that Google (Nasdaq: GOOG) shares have been weighed down by concerns about its upcoming $12.5 billion deal for Motorola Mobility Inc. (NYSE: MMI). A closer look reveals that Google shares may not actually reflect the most negative scenario.

In the investment business, traders talk about an "overhang" -- or a fear factor that weighs on shares. When Google agreed to buy Motorola Mobility Holdings for $12.5 billion, investors immediately fretted about the size of the deal (Google paid a 60% premium on the shares). The deal recently received regulatory clearance in the US and, pending some other reviews, is expected to close in the next few months.

Indeed, the consensus outlook is not that bright. Plenty of analysts and investors are skeptical the deal will work out in Google's favor.

"Dabbling in the phone business is a very dangerous value proposition for Google," says Maribel Lopez, founder of technology analyst firm Lopez Research. "It's not slam dunk creating the hardware. What exactly can Google change about hardware design that wasn't changed by Motorola in five years?"

The investment community is perhaps even more skeptical. One hedge-fund analyst, who asked not to be identified, told me he thought the merger would be "a disaster."

The fear is that the deal will drive down Google's profits and, likewise, its shares. The most obvious concern is that the company is combining a hardware business, which typically has higher expenses and lower margins, with a higher-margin software business. A related worry is that Google isn't really a hardware company, so it will have problems executing on hardware. Google executives have stated on the record that they will keep Motorola as a separately managed unit.

Google shares were punished when the all-cash deal was announced last summer -- which coincided with a generally weak stock market -- but they have rebounded on robust Google earnings.

Optimistic Outlook?

Google shares trade at a premium to Apple, despite the looming threats
of its gigantic $12.5B Motorola Mobility deal.

The party line from Google is that the merger with a hardware company will enable Google to improve its Android mobile business by creating a more tightly integrated hardware and software package, more along the lines of, say, Apple Inc. (Nasdaq: AAPL).

Gartner reported recently Google's Android was the most popular smartphone operating system worldwide among phones sold in the fourth quarter last year. Android had about 51% of the global market sales in the last three months of 2011, compared to Apple, which had about a 24% share.

But competition between Google and Apple has intensified, and Apple has a much larger share of the smartphones sold in the US. Gartner noted that Android vendors are struggling to create unique and differentiated devices. However, it also predicts Apple's share of phone sales could drop in the next couple of quarters as the upgrade cycle to the iPhone 4S slows.

Unlike Apple, Google does not directly benefit from the operating system. It gives away the Android operating system, which it owns, for free.

A more cynical view is that Google just bought Motorola because of its huge patent portfolio -- with something like 17,000 patents, including one for the mobile phone! With Apple and Google enmeshed in a patent battle that pits Android against Apple's iOS for iPhone and iPad, the deal gives Google more legal heft.

In a recent development, Motorola Mobility won a partial court victory in a bid to block iPhone and iPads. The patents relate to 3G technology. The judge ruled that some other patents weren't violated.

One theory holds that Google may well just strip the patents from the company and then spin off the hardware business or sell it. But then there is the question of who is interested in buying a commodity hardware business that competes with Apple.

"I don't know that a hardware business is worth much," says Lopez. "Who would buy it?"

The darkest view is that, as Google attempts to integrate Motorola Mobility, it doesn't go well, it decreases margins, and ends up a drain on cashflow, greatly reducing Google's profitability.

The big question now is how much of this dark scenario is priced in on shares. You can have a look at Google's valuation and compare it to the other "Big Two" -- Apple and Microsoft Corp. (Nasdaq: MSFT), both of which are in mobile operating systems, have huge market caps, and are aggressively pursuing technology patents. (Microsoft recently spent $1 billion acquiring patents from AOL Inc. (NYSE: AOL).)

Here is a chart of their valuations:

So, Google is actually priced at a premium to Apple and Microsoft. Google's profitability compares favorably to Microsoft's but is not as attractive as Apple's. Its valuation metrics, both Price-Earnings (P/E) and Price to Sales (P/S), are actually higher than both Apple and Microsoft. So maybe the markets haven't priced in the darkest scenarios at all.

Does the market think everything will be OK? It will be interesting to see if Google shares start seeing renewed weakness once the deal closes and the work of integration proceeds. The downside threat looms.