Pivotal Research Group analyst Brian Wieser takes a look on Google Inc (NASDAQ:GOOG)’s latest investments away from advertising and media.

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Google-Boston Dynamics acquisition

Last week, news emerged that Google Inc (NASDAQ:GOOG) purchased a company called Boston Dynamics, a manufacturer of robot technologies. This is reportedly the eighth robotics specialist the company has purchased in the past six months, according to the New York Times, including others named Schaft, Industrial Perception, Meka, Bot & Dollay, Redwood Robotics, Autofuss and Holomni. It is unclear how much the company has spent or will spend in the future to develop its robotics initiatives.

Analysta at Pivotal recognize that there are pros and cons around a diversification strategy for Google Inc (NASDAQ:GOOG). Their legacy core business of self-service paid search for small and medium-sized enterprises and e-commerce-based marketers is of course large in absolute terms and high margin, too. There were always clear strategic advantages diversifying away from search when they involved establishing defensive “moats”, as with the company’s expansion into display-related advertising businesses and other digital/web-based  content properties. Acquisitions of YouTube, Android, Doubleclick, AdMob, Zagat and the newly-added Waze all help in this regard.

Google’s diversification might be a problem

However, most of Google Inc (NASDAQ:GOOG)’s recent initiatives are lacking in near-term synergies and do not provide what analysts would realistically consider as defensive capabilities to defend legacy revenue streams or expand emerging ones. Balloon-based internet access for emerging markets, cable overbuilds, wearable electronics, retail and now the robotics investments are among these newer interests. While the company undoubtedly has specific financial goals around every investment it makes, its focus on generating an absolute return on the capital at its disposal strikes us as a form of diversification that is closer to conglomerate-building.

In 1942, science fiction author Isaac Asimov articulated The Three Laws of Robotics, which seems potentially applicable to the analysis of how companies should behave. Consider the Third Law, which (per Wikipedia) states that a “robot must protect its own existence as long as such protection does not conflict with the First or Second Law”. An expansion into robotics, among other efforts to establish a technology conglomerate, could be viewed as Google Inc (NASDAQ:GOOG) protecting its own existence in the very, very long-run as it immunizes itself from the vagaries of advertising spending, whose broader growth trends would otherwise eventually drive Google’s ad growth trends as its market dominance means that at some point years from now, Google Inc (NASDAQ:GOOG) will mirror the total market.

Third Law invocation might be a good thing for Google

Towards this end, invoking the Third Law would be a good thing if analysts view the company’s primary interests as sustaining itself in perpetuity, regardless of what direction the company takes. Asimov’s Second Law partially states that a “robot must obey the orders given to it by human beings, except where such orders would conflict with the First Law.” As Google Inc (NASDAQ:GOOG)’s governance allows its founders to determine the company’s direction, a move towards robots or other forms of business diversification presumably only occur if the founders intended such efforts to occur.

The more interesting question for shareholders to consider is whether or not applications of the Third and Second Laws would be in conflict with Asimov’s First Law that partially states “a robot may not injure a human being or, through inaction, allow a human being to come to harm”. If harm is defined as producing sub-optimal returns on capital relative that may follow declining profit and cash flow margins, conglomeratization is very likely a source of harm for investors over the very long run.

Google poised for more revenue growth

Much trading in Google Inc (NASDAQ:GOOG) in recent months seems to have focused on the company’s strong current and expected near- to mid-term revenue and revenue ex-TAC results, which will undoubtedly remain strong, not least as newer businesses contribute an increasing share of the company’s revenue growth. However, margins for core Google have compressed year over year over each of the past 12 quarters. Analysts think this is largely because the company’s advertising growth has primarily come from the display-related businesses (whose margins are probably significantly lower than revenues associated with paid search), because of fees paid to mobile handset manufacturers for distribution and because of rising costs associated with all of its emerging – mostly diversifying – businesses.

Long-term trends around margin erosion seem all-but-certain to us given the company’s focus on industries which are unlikely to ever be as lucrative as the business mix of several years ago, let alone today’s combination of offerings. And yet consensus forecasts for EBITDA margins indicate expectations of gains from 36% in 2013 to 39% for 2016, with net income margins rising from 25% to 28% over the same time frame.

For now, investors are implicitly saying that diversification does no harm, as sentiment is generally positive and the stock has continued to hold up well subsequent to Google Inc (NASDAQ:GOOG)’s third quarter earnings in the fall. But as analysts see it, the risk remains that many investors will eventually decide that margin compression is undesirable despite topline growth, at which point the Third and Second Laws might eventually be in conflict with the First one for the bulk of Google’s shareholders.