Why Google Will Spend $3.2 Billion to Buy Nest

Internet giant Google (NASDAQ: GOOGL  ) announced early this week that it is acquiring Nest Labs, a maker of intelligent smoke alarms and thermostats, for $3.2 billion in cash. Nest Labs was founded by former Apple (NASDAQ: AAPL  ) employee and "godfather of the iPod" Tony Fadell, who has authored more than 300 patents in his 20-plus years of experience in the consumer industry, and Matt Rogers, who also worked at Apple developing iPod and iPhone software.

The last time it raised new funding, Nest Lab managed to get a $2 billion valuation. This suggests that Google is probably going to pay more than $1 billion as a premium for the start-up. Although Google has plenty of cash in its balance sheet, the deal's high premium is bound to raise some eyebrows in the coming days. Why did Google pay so much to acquire Nest Labs?

Source: Nest Corporate Website

Beyond web ads
Simply put, this acquisition shows Google's strong interest in diversifying its Internet business. As Morningstar Rick Summer notes, "Google is highly leveraged to its exposure to the Internet search industry, because more than 80% of its net revenue is generated by this activity."

This means that the company is heavily exposed to the global demand for digital ads, which depends enormously on macroeconomic conditions. To reduce this risk, Google is moving deeper into web-connected devices, as evidenced by the development of Google Glass, and the $12.4 billion acquisition of Motorola Mobility in 2012.

Amazing technology
By acquiring Nest Labs, Google will have access to high-tech versions of thermostats and smoke detectors.  Nest Labs' thermostat is said to be able to lower heating and cooling bills up to 20%. It learns the customer's schedule, programs itself, and can be controller from a smartphone. The smoke alarm, on the other hand, constantly monitors its batteries and sensors.

More importantly, Nest's products track not only a home's temperature, but also when people wake up, leave to work, and return home. This information could be eventually tied to a Google account. By integrating Nest technology with Google products, users who log in to their Gmails could see their home's temperature, or get mail alerts about smoke presence.

The Internet of Things is going mainstream
Google's latest acquisition is a huge bet on the Internet of Things, a new tech paradigm that aims to embed daily life objects -- from TVs to thermostats -- with the ability to stay connected to the Internet via connectivity sensors. 

Investors interested in adding full exposure to the Internet of Things do well in adding Cisco Systems (NASDAQ: CSCO  ) to their watch list. Although Cisco System does not manufacture gadgets, the company is the world's largest supplier of data networking hardware and software, and is set to benefit enormously from an increase in demand for connectivity sensors. The company introduced a network fabric family designed to deliver scalable, smarter, and more adaptable Internet three months ago.

Google needs Nest more than Apple needs Nest
According to Business Insider, Nest Labs, formed by two important Apple employees, has been hiring many Apple engineers recently. There's even a report that one of the engineers working on Apple's iWatch joined Nest Labs. Therefore, it's natural to wonder if Apple, as a leading manufacturer of gadgets, was ever interested in this deal.

But according to tech analyst Richard Neiva, the possibility that Nest Labs was never really on Apple's wish list does exist. Apple very rarely buys a company with an end product. Moreover, according to IDC analyst Johnatan Gaw, Nest Lab's main strength relies in design, rather than technology. And design is a field where Apple already has plenty of competitive advantages.

Final Foolish takeaway
Initially, Google tried to differentiate itself from Apple by giving software to hardware manufacturers. That's why the company open-sourced Android. The acquisition of Nest Labs shows a shift away from this strategy: The new Google needs to manufacture hardware, specifically smart gadgets, that can be tied to a Google account.

The premium paid for the start-up does look expensive in the short run. However, this acquisition could make sense in the long run, if Google manages to integrate Nest products to its software, and keep Nest Lab's team engaged in new products.

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