In a report issued on Wednesday, Wells Fargo Securities downgraded Google's stock from Outperform to Market Perform, meaning that it no longer expects Google's stock to generate returns better than market averages. The report predicts Google will report net revenue of $8.31 billion, and earnings per share of $10.45, just below the consensus estimate of $8.37 billion and $10.50, respectively.
The securities firm's tepid endorsement stems from six potential problems facing Google, issues that could constrain Google's ability to grow its business.
1. Integrating Motorola Mobility. Google is in the process of acquiring mobile phone handset maker Motorola Mobility (MMI). The $12.5 billion deal is expected to close early this year. Google agreed to acquire MMI partially to bolster its patent holdings, necessary to defend against the patent claims that have been brought against the company and its hardware partners over its Android mobile operating system.
[ Google joined other popular websites in a protest against proposed anti-piracy legislation. Read Google, Mozilla, Wikipedia Fight SOPA Piracy Bill. ]
But Jason Maynard, senior analyst for Wells Fargo Securities, says in the report that his firm believes Google intends to make use of MMI's hardware business, rather than spin it off. In the long term, Google could become a company that profits from products that combine its own software and hardware, much like Amazon, Apple, and Microsoft do. But in the near term, the integration poses operational risks.
Google's effort to promote and support its Android operating system can be compared to herding cats--the company's hardware and carrier partners have minds of their own and sometimes don't act the way Google would prefer. Android has benefited from the fact that Apple initially made its iPhone available only through AT&T and from the strong offerings peddled by hardware partners such as HTC, MMI, and Samsung.
With MMI on its way to becoming a Google-owned company and Nokia linked to Microsoft, Google now finds itself herding cats amid fireworks: Its allies are looking over their shoulders, worrying about patent lawsuits, Android fragmentation, and competitors. They're struggling to find ways to differentiate their own Android handsets from those offered by other Google allies.
Google might find that HP's disastrous bid to replicate Apple's own-the-whole-stack business model by acquiring Palm helps dissuade allies such as Samsung from pursuing paths toward independence. But Maynard argues that Google's pending acquisition of MMI and growing optimism about Microsoft's Windows 8 and Windows Phone could push Samsung in the opposite direction.
"We think the pending acquisition of MMI could complicate matters and create a 'window' of opportunity (pun intended) for Microsoft’s mobile OS and potentially cause a rift in the important Samsung relationship," the report states.
2. Difficulties with continued search advertising improvements. Despite ongoing search-quality improvements and services such as Google Instant and travel search, Maynard and his colleagues believe that further gains won't come at the same rate and that, as a consequence, paid click revenue will grow more slowly than in the past. To put it another way, the addition of Google+ posts to search results isn't expected to make Google's online ads perform better.
3. Exploding headcount. As Google pursues growth in areas tangential to its core search-advertising business, it has been hiring new people more rapidly than many financial analysts believe is prudent. Google has consistently defended hiring to fuel growth and innovation, but Maynard in his report sees Google's headcount, along with marketing, development, and logistical costs, putting pressure on profits.
4. Regulatory trouble. Google has attracted considerable regulatory scrutiny both in the U.S. and in Europe. The Federal Trade Commission, which has been looking into whether Google conducts its search business in a fair manner, is said to have expanded its fact finding to include Google's recent decision to promote Google+ content through its search results lists. And Reuters on Wednesday reported that EU officials will decide in March--sooner than expected--whether to file a formal complaint against Google.
"While we don’t expect any final outcomes in 2012, we worry an overzealous regulatory body could at the very least crimp the company's acquisition plans, business strategy, or consume management time and attention," the report says.
5. Less-favorable currency exchange rates. Like other successful multinational companies, Google has benefited from favorable exchange rates. Maynard suggests over 4 percentage points of Google's fiscal-year 2011 revenue growth can be attributed to a weak dollar. The report cites a declining euro and rising dollar as trends that could diminish the benefits of revenue earned abroad.
6. Diminished potential for high-margin valuation.. The report suggests that following Google's integration of MMI, Google will be valued as a combined software and hardware company, like Apple, rather than as a pure software company. Because hardware margins are generally lower than than software margins, the report anticipates Google trading at a 12x price-earnings ratio rather than at 14x PE.
For all these potential problems, Google still has plenty going for it. The report points to CEO Larry Page, Google+, Android monetization potential, YouTube and display advertising, and Android growth as positive factors. Not mentioned, but worth noting for their revenue potential, are products such as Google Apps, Google Chrome, Google Voice, and Google App Engine.
Google typically reports its quarterly results on its website just after U.S. markets close, at 4 p.m. eastern time.
For the 15th consecutive year, InformationWeek is conducting its U.S. IT Salary Survey. Upon completion of the survey, you will be eligible to enter a contest for prizes including a Bravia HDTV or iPad 2, and get a link to download our report once it is published. Take the survey now. Survey ends Jan. 20.