Google’s Plans Could Threaten Phone Partners

Google could undermine its long-term strategy of extending its reach into mobile Web services if it chooses to go head-to-head with cell phone manufacturers that are using its Android operating system.

Analysts say Google’s ultimate success rests on phones of all sorts using its Web search and services — the lion’s share of its revenue — a goal that Google (NASDAQ: GOOG) could jeopardize by offering a mobile phone that competes against those of its partners.

Google, which sources say will push out its own phone as early as 2010, may be making a multibillion-dollar mistake and should focus on getting its Android operating system software on as many phones as it can, to draw in consumers for its bread-and-butter Web search and services.

Google is “going to box themselves more and more in a corner by actually making these phones,” said Anil Doradla, an analyst with William Blair & Company.

With details scarce for now, analysts struggle to understand Google’s move into a highly competitive business in which it has no experience.

Some say the world’s No. 1 Internet search engine is trying to temper Apple’s (NASDAQ: APPL) dominance in the smart phone market as it tries to publicize Android.

Phones using Google’s Android smart phone software — announced this year — have lagged Apple’s iPhone in sales and reputation, and the search leader’s decision to make its own hardware device could solve that problem.

Unlike Apple, whose roots in the hardware design business helped its entry into the cell phone market, Google’s has expertise in Web-based software that may not necessarily translate into consumer electronics prowess.

Conversely, smart phone software like Android ensures that the company’s advertising-based Web services get prominent placement on the new breed of mobile devices and could give Google better access to valuable data, like a person’s location, which can be used to sell targeted ads for a premium price.

Android’s rapid rise

Google has had early success convincing phone makers to adopt its Android software. Android is currently available on more than 12 different phones from vendors including Motorola and Samsung, with more devices coming from Sony-Ericsson, LG Electronics and Acer.

That support may fade as Google moves forward with plans to develop its own, Google-branded Android phone to be sold directly to consumers, as a source familiar with the matter told Reuters the company is doing.

“If the most essential element of your phone is coming from a competitor, it’s not good. Not in any industry,” said Doradla, in reference to phone makers that are currently using Google’s Android software.

Signal Hill Group analyst Todd Greenwald said Google, which has a market cap of $189 billion and roughly $22 billion of cash and securities, may figure it is big enough that it can risk upsetting certain partners.

Next page: The hardware challenge

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Motorola, which is struggling to mount a comeback and has built its new line of phone products around Android, does not appear to have many alternatives, said analysts. An official from Motorola was not immediately available for comment.

At least one wireless carrier appears to be on board with Google’s strategy: Deutsche Telekom’s T-Mobile USA is set to offer a subsidized version of the Google phone to U.S. consumers who agree to a wireless service contact with the carrier, according to the person familiar with the matter.

Among the other questions raised by Google’s move is how an Internet company will fare in the hardware market.

Compared with the rich profits Google enjoys, hardware device makers survive on thin margins, ever vulnerable to oversupplies and shortages of inventory components and manufacturing capacity.

The risk of a low-margin hardware business

“The risk for Google is a multibillion mistake of a foray into the chronically low-margin hardware business,” said CCS Insight analyst John Jackson.

Google’s inexperience in the hardware business could make it tough for the company to get ahead of the competition on design alone, said Jackson.

He speculated that Google will have to find other ways to innovate, including potentially offering some sort of free device or free service by subsidizing a consumer’s wireless airtime, if the company hopes to gain market share.

Goldman Sachs analyst James Mitchell wrote in a note to investors on Tuesday that the potential ad revenue from smart phone users could allow Google to subsidize as much as $50 to $100 of the retail price of each phone. But even with that discount, and assuming Google forgoes its own profit margins on the phones to reduce the price tag further, Mitchell wrote that the Google phone would still be more expensive than the phones available to U.S. consumers through traditional wireless carrier subsidies.

Given the many challenges of competing in the hardware business, Signal Hill’s Greenwald suggested that Google’s primary aim was to point the way for other handset makers, rather than serving as a basic business for Google itself.

“I really think that they are just trying to spur the process along, to introduce something out there that has all the features that they think consumers want,” said Greenwald.

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