Why Hardware Will Make Google More Volatile

by Brad Moon | August 16, 2012 6:30 am

For a search engine company that makes over 95% of its revenue from advertising[1], Google (NASDAQ:GOOG[2]) is sure getting deep into the hardware manufacturing business. That’s not only a leap from its core competency, but the areas where Google has chosen to compete are brutally competitive and tend to be dominated by a very few companies, including Apple (NASDAQ:AAPL[3]).

Take the mobile phone business. Google is already all over smartphones as the company that owns Android — the operating system used on a huge range of handsets, including those offered by Samsung. Android is also the OS running smartphones made by Motorola Mobility, the company Google paid $12.5 billion to buy earlier this year.

However, despite being the owner of an operating system employed by just under 100 million smartphones shipped worldwide in Q2 of 2012[4] (Apple’s iOS powered 28.9 million units during the same period), Google makes very little money from Android. In fact it gives the OS away to vendors for free.

According to an article in The Guardian, Google submitted data in its trial with Oracle (NASDAQ:ORCL[5]) that shows it earned less than $550 million in revenue from Android[6] between 2008 and year-end 2011. This includes the Android spin-off revenue such as sales of apps.

That number helps to explain why Google is interested in building its own (Motorola) smartphones, as well as its venture into tablet manufacturing with the Nexus 7[7]. A big reason why Android has failed to haul in more revenue for Google: The operating system’s openness means vendors can bypass functions and slip in their own features.

For example, Amazon’s (NASDAQ:AMZN[8]) Kindle Fire — which was the best-selling Android tablet for the months over the Christmas holidays — runs Android, but without functionality related to Google’s online stores. So apps, e-books, movies and music (all the areas where Google would like to generate revenue from those hundreds of millions of Android devices) were bought from Amazon instead.

One big question is whether Google will continue with its tablet sales model (sell the Nexus 7 at break-even or a loss, and hope to make it up through online content purchases), or take the Apple approach to hardware and shoot for high-margin pricing that results in big profits for each unit sold. A different approach for different products sends a mixed message that can confuse consumers.

It’s a bit tougher to figure out the Nexus Q, the spherical multimedia streaming device Google introduced recently alongside the Nexus 7. Expensive, proprietary and limited in functionality, the Nexus Q was clearly intended to promote Play[9], Google’s cloud music locker, and provide some sort of Android alternative to the huge range of speaker docks and streaming devices bearing the “Made for iPhone[10]” badge.

Google also played up the Nexus Q’s “Made in America[11]” cred. Unfortunately, the device was a clear miss with reviewers — and Google has gone back to the drawing board for now. Besides bruising Google’s ego, the Nexus Q flub[12] introduced a little bit of a PR issue when the company announced it would be laying off some 4,000 Motorola workers — 1,300 of them in the U.S. Yes, the bulk of the cuts are in other countries, but it still blunts a play for goodwill when you trumpet your effort to manufacture a product in the U.S., and then one of your divisions whacks American employees.

Manufacturing hardware also introduces a level of chaos to a company, especially if it becomes a significant chunk of revenue. While Google’s ad revenue growth may slow or speed up from quarter to quarter, its broad nature (search-driven ad revenue is spread across a huge range of devices, platforms and users) makes a sudden, big change unlikely.

Hardware, however, can result in massive fluctuations in the bottom line. The lead-up to a big product launch can involve billions of dollars in expenditures to secure needed components. Hardware is a hard sell, and success requires big marketing expenditures. Apple spent nearly $1 billion[13] last year flogging iPhones, iPads and its other products.

There’s also the possibility a new smartphone or tablet will flop, despite the money spent. Research In Motion (NASDAQ:RIMM[14]) reportedly lost in the range of $1.5 billion[15] on its PlayBook tablets.

And even when a gadget is a runaway success — like Apple’s iPhone 4S — sales can quickly plummet as consumers glom on to the next must-have, or wait for a successor. That scenario played out for Apple (which is expected to announce its latest iPhone within the next month) when Q3 2012 iPhone sales dropped 26% over the previous quarter[16].

For Google, this increased foray into hardware holds the opportunity for increased profits through device sales (especially if that can help one-time mobile star Motorola get its mojo back), by pushing more revenue through its online stores and by grabbing a bigger chunk of mobile ad revenue. At the same time, Google’s products are going into a tough market. In the smartphone arena, 90 cents of every dollar in profit goes directly to the coffers of Apple or Samsung.

While it may be the right move in the long term — if Google can successfully pull it off — selling hardware is liable to introduce a level of volatility to Google’s bottom line that investors haven’t been accustomed to.

As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.

Endnotes:
  1. over 95% of its revenue from advertising: http://venturebeat.com/2012/01/29/google-advertising/
  2. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  3. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  4. 100 million smartphones shipped worldwide in Q2 of 2012: http://www.guardian.co.uk/technology/2012/aug/14/android-smartphones-iphone-2012-2q?newsfeed=true
  5. ORCL: http://studio-5.financialcontent.com/investplace/quote?Symbol=ORCL
  6. earned less than $550 million in revenue from Android: http://www.guardian.co.uk/technology/2012/mar/29/google-earns-more-iphone-android
  7. Nexus 7: http://investorplace.com/2012/06/google-is-finally-set-to-unveil-its-tablet/
  8. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  9. Play: https://play.google.com/about/
  10. Made for iPhone: http://support.apple.com/kb/HT1665?viewlocale=en_US&locale=en_US
  11. Made in America: http://www.nytimes.com/2012/06/28/technology/google-and-others-give-manufacturing-in-the-us-a-try.html?_r=2&pagewanted=all
  12. Nexus Q flub: http://investorplace.com/2012/08/how-google-flubbed-its-nexus-q/
  13. Apple spent nearly $1 billion: http://www.forbes.com/sites/ycharts/2012/08/02/who-spends-more-on-ads-apple-or-microsoft-another-lesson-in-quality-vs-quantity/
  14. RIMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=RIMM
  15. lost in the range of $1.5 billion: http://www.guardian.co.uk/technology/blog/2011/dec/05/playbook-writeoff-rim-tablet-mistake
  16. dropped 26% over the previous quarter: http://techcrunch.com/2012/07/24/apple-q3-2012-26m-iphones-17m-ipads-4m-macs-and-6-8m-ipods/

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