Up to 4% Downside for Google if Oracle Prevails in Android Suit

Oracle (NASDAQ:ORCL)recently filed a lawsuit against Google (NASDAQ:GOOG), claiming that Google’s Android software infringes on seven Oracle patents and copyrights related to Java software.

Google’s Android operating system is used in smartphones, and competes with Apple (NASDAQ:AAPL), Research in Motion (NASDAQ:RIMM) and Nokia (NYSE:NOK) in this segment.

If Oracle wins this case, we see a potential  1-4% upside to the $35 Trefis price estimate for Oracle’s stock, and a similar downside to our $683 stock price estimate for Google. Our analysis follows below.

Oracle’s lawsuit

Java is a popular, open-source programming language that was originally developed by Sun Microsystems. It is designed to produce applications that can run in any computing environment. Oracle gained certain rights to Java  when it acquired Sun for $7.4 billion in 2009.

Today, Java is commonly used to build mobile phone applications and games. In order to build specific Java applications, software engineers create “virtual machines”, which are software environments that mimic computer hardware. In essence, Java applications run anywhere because they run within these virtual machines.

Google’s popular mobile phone operating system, Android, is based in part on a Java virtual machine called Dalvik. (It should be noted that Google’s CEO, Eric Schmidt, led the development of Java as a senior executive at Sun in the early 1990s.) Oracle claims that Dalvik  infringes several of its Java patents. Google has denied these allegations.

Android’s rise

Android’s share of the global smartphone operating system market recently surpassed that of Apple’s iPhone OS. By the second quarter of 2010, Android’s smartphone market share stood at around 17.2%, up from just 1.8% a year ago, according to technology research firm Gartner.

We estimate that around 220 million smartphones will be sold globally in 2010, rising to about 640 million by the end of the Trefis forecast period. We expect Android’s share of this market to reach 43% by the end of our forecast period, which suggests that annual Android-based smartphone sales will reach 275 million by 2016.

Impact on Oracle and Google

Oracle’s licensing revenues from Java and Solaris (a data center operating system that was also developed by Sun) grew from around $500 million in 2005 to about $690 million in 2009.  We expect revenues from these two applications to reach $1 billion by the end of the Trefis forecast period.

You can drag the trend-line in the chart below to create your own Java/Solaris revenue forecast and see how it impacts Oracle’s stock price.

If Oracle prevails in its lawsuit, it may force Google to pay royalties on Android, which Google currently distributes free to smartphone manufacturers. We estimate that Oracle may end up charging a royalty of $1 to $3 on the sale of every Android-based smartphone, implying annual royalty payments from Google of $275 million to $825 million by the end of our forecast period based on our forecast of 275 million Android-based smarpthone sales.

Under these scenarios, Oracle’s Java/Solaris revenues would rise to a range of $1.3 billion to $1.84 billion by 2016, instead of the $1 billion that we currently forecast. This yields a potential upside of 1-4% to our stock price estimate for Oracle.

We believe that Google will not try to pass on royalty costs associated the use of Java in the Android OS to mobile phone makers or telecom operators.  This means that Google will absorb the additional costs associated with royalty payments to Oracle and our back-of-the-envelope calculation suggests a potential 1-4% downside to our price estimate for Google as a result. 

You can see the complete $35 Trefis Price estimate for Oracle’s stock here. You can see the complete $683 Trefis Price estimate for Google’s stock here.