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Rarely has any company put so much on the line as Google (GOOG) has with its purchase of struggling cell-phone maker Motorola Mobility (MMI). When the $12.5 billion deal was announced last August, analysts focused primarily on what Motorola’s more than 17,000 patents (rather than its hardware expertise) would do for Google, which was in the midst of an escalating legal skirmish with Apple (AAPL) and others over its Android smartphones.
Turns out Google has greater ambitions than just building out its patent portfolio. On Feb. 10, the Wall Street Journal broke the news that Google is working on an audio-streaming device for the living room. Since Motorola is already the market leader in cable set-top boxes, it’s likely such a device could also be used to distribute television, movies, and other digital fare. The San Jose Mercury News subsequently reported on $120 million in new architectural projects at the Googleplex in Mountain View, Calif., including advanced hardware-testing facilities.
Google Chief Executive Officer Larry Page is clearly looking beyond not just search—still the main cog in its profit-making machine—but software entirely. Here’s why: Apple’s $465 billion-odd market capitalization is currently greater than Microsoft (MSFT), Google, and Nokia (NOK) combined, thanks to its ecosystem of tightly integrated hardware and software products. “The line between hardware and software is indistinct and arbitrary, especially in mobile devices,” says Paul Saffo, a consultant with Discern. “You need to control the hardware to control the overall experience.”
If Google hardware takes off—in the form of phones, tablets, TVs, and maybe even visors with Terminator-like information overlays—it would more tightly tie consumers to the company’s products such as search and YouTube. The goal wouldn’t necessarily be to make money on the hardware but to create more ways for Google to serve up the ads that brought in 96 percent of the company’s $37.9 billion sales in 2011. “Google will remain an advertising company, and they’ll use hardware to grow that business,” predicts Aaron Kessler, an analyst with Raymond James Financial (RJF).
Even in the best of scenarios, digesting Motorola will be a challenge. The company, with 20,000 employees, lost 20 percent of its market share in 2011, though the cell-phone maker did manage to earn $98 million on $13 billion in revenue. Motorola will likely drag down Google’s earnings for years to come. Barclays (BCS) analyst Anthony DiClemente assumes that the combined company will deliver profit margins of 41 percent in 2012, vs. 55 percent if Google remains separate from Motorola. “I didn’t like the deal, but hey, the button’s been pushed,” says Colin Gillis, an analyst with tech consultancy BGC Partners (BGCP).
Google’s dive into hardware could also alienate device makers like Samsung and HTC, which rely on the Android operating system for almost all their phones. If Google prioritizes Motorola over its competitors—say, giving it earlier access to Android upgrades—they might rely more on other operating systems, such as Microsoft’s soon-to-be-released Windows 8. “They need to be very careful that they don’t damage the ecosystem they’ve so carefully built,” says Bill Whyman, an analyst with International Strategy & Investment Group. Otherwise, he warns, the results could be “disastrous.”
Google risks stepping on other toes, too. In recent days, the company’s construction crews have begun stringing fiber-optic lines in Kansas City for a superfast broadband service scheduled to go live this summer, says Jeff Heynen, an analyst with Infonetics Research. Google says its goal is to prove it’s possible to affordably deploy networks 100 times faster than the U.S. average, but carriers such as AT&T (T) and Verizon Communications worry that an innovative, cash-rich rival will start setting up shop in other cities. “You can bet the current broadband providers are watching closely,” says Heynen. Those same Internet service providers happen to control the cellular airwaves and could make life more difficult for any Google mobile product.
Then there’s the basic challenge of making and selling hardware. It’s taken Apple decades to perfect a lean, adaptable supply chain that minimizes inventories and customer service wait times. Google doesn’t (yet) have retail stores nor even a phone number to field customer questions. Also, Google’s first dalliances with making hardware haven’t been promising. It worked closely with device makers to create its own smartphones under the Nexus brand, which were designed to show off all the bells and whistles possible with Google software, like turn-by-turn navigation. Nexus sales have never been particularly strong. Google TV, a joint project with set-top box manufacturers to bring the Web to television sets, has been even more disappointing. Last year Logitech (LOGI) announced it would stop making the devices because of underwhelming sales—and chalked up a loss of $100 million due to the failure.
And finally, Google isn’t the only software company to recognize the need to be a force in hardware. Microsoft has a hit in the form of its Xbox console and the motion-sensing Kinect add-on, which offer ways for consumers to interact with a whole ecosystem of Microsoft services from their living room. Amazon (AMZN) debuted its Kindle Fire tablet late last year and, while the company reportedly takes a loss on each $199 device, RBC Capital Markets analyst Ross Sandler believes the company will earn $136 on each unit from sales of books and movies. Even Facebook is rumored to be readying a phone of its own.
There are, in short, many reasons why Google’s move away from products based on bits to those made of atoms is risky—but avoiding risks has never been a formula for success in the fast-changing tech world. “Google is still run by its founders, and they’re not willing to say, ‘OK, I guess we’re mature, let’s start giving the cash back to shareholders in dividends and go quietly into the night,” says Whyman. “If that means they have to get their hands dirty with hardware, then so be it.”
The bottom line: Google’s push into hardware could cement its dominance in ad sales—and scare off investors and partners like Samsung and HTC.