Are Cheap Google-Motorola Smartphones on the Way?

A year from now, would you purchase an iPhone 6 for $200 if you could get a Google–Motorola Droid 5 smartphone for $50-100 with a 2-year plan from AT&T (NYSE:T) or Verizon (NYSE:VZ)?  While many look at Apple’s (NASDAQ:AAPL) high mobile phone profits and wonder whether Google or anyone else can replicate its success, the reality may be that Google doesn’t need to. In fact it may have no intent of generating high profit margins from its newly acquired Motorola Mobility (NYSE:MMI) mobile phone business… or at least not over the next few years.

At the end of the day, Google makes the bulk of its money from Internet search advertising and wants to keep doing so, and so the Motorola deal was consummated with this in mind.   We estimate that search advertising accounts for 66% of our $600 price estimate for Google, which is around 10% ahead of the market.

Google’s Motivation is Mobile Search & Mobile Advertising

Google’s primary objective is to make sure that the Android platform remains the predominant mobile operating system.  Why?  Because an increasing number of Internet searches will be conducted on mobile phones and more online ad dollars will shift to mobile advertising (mobile search, localized search and localized deals). This is the motivation behind Google’s acquisition of AdMob as well as the launch of Google Deals.

Google Can Give Away Something Good Enough at a Low Price

While it may be hard for Google-Motorola to beat Apple when it comes to hardware design, it doesn’t really need to.  Motorola’s Droid is already a capable mobile phone in terms of hardware and the Android app platform is growing rapidly.  Google needs to tip demand in its favor by giving a good enough smartphone away at a low price.  Currently both the iPhone 4 and Droid 3 sell for $200 from Verizon with a 2-year contract.  And impressively, Droid sells at the same price point as the iPhone. So there is clearly an opportunity to stimulate more demand for the Droid vis-a-vis the iPhone by adjusting pricing.

Motorola Isn’t Profitable Anyway

Motorola isn’t profitable in the first place and Google’s motivation in the near term is certainly not profits with respect to this purchase.

Motorola had $23 million of operating losses on $3.3 billion in Q2 2011 revenues. Let’s say Google ended up selling 5 million Android mobiles phones a quarter at $100 less than Motorola would have as a standalone company that would be about $500 million in quarterly losses that Google would have to absorb. Google had about $2.9 billion in Q2 2011 income from operations which gives the company some cushion for losses. In comparison, Apple had $9.4 billion in operating income during the most recent quarter.

Will You Search 14 Times a Day?

While Google may be willing to lose money on the hardware, it has the potential to recoup it based on mobile searches alone.  Future Droids may come at a low price if you agree to have Google as the exclusive search bar and default browser search on the phone.

We estimate that Google will earn about $14 for every 1,000 searches it serves in 2011.  This includes searches conducted outside the U.S., particularly in emerging markets where ad rates are lower.  Let’s say that Google can earn $20 per 1,000 searches in the U.S.  How many searches does Google need you to make to recoup $200 over a 2 year contract period? That works out to 10,000 searches or 14 times per day.

Now that may be on the high side, but if Google priced Droid at $100 instead of giving it away for free, then it would only need you to search 7 times per day.  And this excludes whatever Google may make from other mobile ads and mobile deals it provides.

You can modify the forecast below to see how Google’s stock would be impacted if the monthly searches per internet user were to rise faster than we currently forecast as a result of a stronger Google presence in the mobile phone market.

Downside for Margins of Apple, RIM, Nokia & Google’s Partners

If Google were to pursue this strategy, it would certainly put pressure on Apple.  You can modify our forecast for iPhone gross profit margins below to see how the Trefis price for Apple would be impacted if Apple’s margins were to decline faster than we forecast.

This strategy would also have potentially devastating implications for Nokia and RIM.  One of the main factors favoring Nokia and RIM phones outside the U.S. is that unsubsidized iPhones are extremely expensive.  This provides an advantage to Google to pick up share outside of the U.S. at the expense of other mobile players.  However, such a strategy would also make life harder for Google’s remaining Android partners (HTC, LG, Samsung).  This implies Google may concentrate its strategy on the U.S. in the near-term and concede international markets to its partners.

See our complete analysis for Google’s stock.