Raymond James analysts Tavis C. McCourt and Daniel Toomey highlight the implications of the Nest Labs acquisition by Google Inc (NASDAQ:GOOG).

Google Inc GOOG

Google acquires Nest Labs

Google Inc (NASDAQ:GOOG) announced on Monday afternoon its acquisition of Nest Labs for $3.2 billion in cash. Nest makes smart home devices including the $250 Nest Learning Thermostat which can learn a homeowner’s climate preferences and begin to adjust the temperature automatically to conserve energy and lower heating and cooling costs. The company also sells the $129 Nest Protect, a connected smoke/carbon monoxide detector which can be controlled and send alerts via smartphone.

The company was founded by two former Apple Inc. (NASDAQ:AAPL) engineers who were instrumental in the development of the iPod and the iPhone, Tony Faddell and Matt Rogers. Nest will be run independently under Google Inc (NASDAQ:GOOG)’s ownership and will continue to be led by Faddell and Rogers. Google’s venture capital arm, Google Ventures, was a major investor in Nest Labs having led its Series B and C financing rounds. The deal has not closed and has yet to meet regulatory approval. Here are our initial thoughts…

Google’s second hardware acquisition

Importantly, Nest Labs is not an open software platform given away for free, it is a device business that sells physical hardware at a profit, with the design of the device, its machine learning algorithms, and its interconnectivity with smartphone apps being the key features. It is a business with retail presence, customer service obligations, and has more in common with the company’s Motorola acquisition than anything else that Google Inc (NASDAQ:GOOG) has acquired.

Does Apple or Microsoft Need to Follow Google’s Lead?

Need would be a strong word, but we do believe the realm of connected devices leads to a number of interesting buy/build/partner decisions for large ecosystem/OS players. Cars are quickly becoming connected, does this mean Apple Inc. (NASDAQ:AAPL) or Microsoft Corporation (NASDAQ:MSFT) needs to make cars? Or just integrate with infotainment vendors to ensure that iOS or Windows is represented? It’s the same in home automation. Is it enough just to have what is in effect the remote control for home automation platforms (iPad/iPhone)? Or does Apple want to make the devices as well? Our view is that ultimately, the company may transition its WiFi router into a fully functioning home automation hub with Zigbee, Bluetooth, Wifi, (Qualcomm and Broadcom are already enabling this from a chip perspective), but this would be a very small market opportunity for a company Apple or Microsoft’s size. However, it wouldn’t be outrageous to see Apple make an acquisition or build a team internally to make the peripheral devices in home automation as well as provide a way to extend its design expertise into product markets that can actually move the needle in terms of revenues for Apple. We would view Microsoft as being in a similar position as it must decide in what way it extends its vision for one Windows platform extended into connected devices.

Google making a huge bet on home automation

Essentially, this purchase price guarantees that Google will not only attempt to “globalize” Nest, but likely move into other product lines beyond thermostats and smoke detectors as well. However, much of this purchase price may just be the price Google Inc (NASDAQ:GOOG) has to pay to attain the founders and talented engineering team at Nest Labs. Although we would like to say Google is making a huge bet on home automation, it may be simply attempting to bring on some engineers with an amazing pedigree at bringing connected devices to market (including the iPod and iPhone). This experience could help Google on a number of fronts.

Nest is not an open platform

Nest historically is much more similar to Apple Inc. (NASDAQ:AAPL)’s business model than Google’s. Up until recently, the thermostat did not interoperate with any other appliances in the home (Control4 was its first partner for interoperability that we are aware of). Nest is opening up the ecosystem slowly, and it is unclear whether this will change under Google’s leadership. However, at some point, Google Inc (NASDAQ:GOOG) and Nest will need to decide how open they would like to make Nest or whether they would like to keep a mostly closed ecosystem that locks consumers into controlling multiple Nest devices/appliances in the home.

Home automation cannot be monetized

This goes without saying, but it is interesting nonetheless, as the vast majority of Google Inc (NASDAQ:GOOG)’s businesses are monetizable either through search or online advertising.

Was There a Bidding War?

Although it is hard to know, $3.2 billion is a high price, and if there was more than one bidder, that means there is at least another large technology company apparently willing to pay a lot of money for the right home automation asset.

Maybe Hardware Is Cool Again?

Although financials for Nest are not available, we believe the purchase price represents a revenue multiple of well over 10x for what is essentially a “hardware” company in the same way as Apple Inc. (NASDAQ:AAPL), Garmin Ltd. (NASDAQ:GRMN), Control4 Corp (NASDAQ:CTRL) and a number of other perceived “hardware” or “device” companies that sell hardware with imbedded connectivity and an ecosystem to drive higher than commodity margins. Although hardware has its challenges, and especially consumer-oriented hardware, it has its upsides too, which include generally very large market opportunities (the home appliance market is well over $100 billion annually) and very quick revenue and profitability ramps relative to cloud-based software. The secret to building sustainably high margins in consumer devices is the development of an ecosystem that essentially locks consumers into purchasing your devices. Apple has achieved this with iTunes and the App Store, Garmin has achieved it with its Garmin Connect web site, Control4 does this through its interoperability with third-party devices, GoPro has achieved this through its proprietary peripherals, and we suspect Nest/Google will be building a similar ecosystem concept as well to ensure that substantial consumer demand turns into a sustainable, high-margin business.

Control4’s valuation is a highlight given this transaction

Although not a traditional retail-oriented vendor, Control4 Corp (NASDAQ:CTRL)’s home automation software and hardware is far more interoperable than Nest’s, has the benefit of 10+ years of development/IP accumulation (~50 patents/pending), and serves as a broader OS/ecosystem that interoperates with just about any home appliance. With an EV of ~$400 million and EV/Sales of 3x, CTRL’s valuation would seem to be reasonably attractive if home automation becomes a “must have” asset for large technology vendors or begins to become a mainstream consumer product.9) NETGEAR in the Market As Well: Although just now entering, NETGEAR makes a truly differentiated video surveillance camera for the home sold through retail channels, and will likely expand its portfolio in the coming years. There are dozens of ODMs in Asia with reference designs for thermostats, lighting systems, smoke detectors, etc. In other words, there will be a very large market for more mainstream-priced connected devices in the home, and NETGEAR has an opportunity to tap into this.

The private company landscape

Although we doubt venture capitalists will start chasing home automation business plans as aggressively as they have cloud software business plans over the last five years, there are a number of smaller private companies that

1, 2  - View Full Page