Google May Soon Face Its Biggest Challenge Yet

| About: Alphabet Inc. (GOOG)


Google's upcoming stock distribution could be a tremendous challenge.

Apple will be impacted by this event in some fashion.

The outcome of this distribution will have an impact on many market indexes and ETFs.

Sometimes, a stock's biggest threat may not come from competition, the economy, or the weather. This threat may come from inside the company, and it usually comes from decisions made by management or the board. Google (NASDAQ:GOOG) may soon face its biggest challenge, and it has nothing to do with search engines, operating systems, or futuristic technology. If you don't know what I'm talking about, it's the upcoming "stock split" or stock distribution. This challenge may test the company and its investors. Today, I'll examine this complex procedure, and what it means for Google, Apple (NASDAQ:AAPL), and the overall market.

What's going on here?

Investors may not remember that Google planned on splitting its stock, or distributing a new class of shares to its shareholders. The reason why this news had been lost for a while is a number of lawsuits held up the proposed distribution. Investors were concerned that the new class of shares could end up trading at a severe discount. Eventually, a settlement was reached. Here's what Google stated in the most recent 10-K filing about the upcoming event, which will occur for shareholders as of March 27th.

In April 2012, our board of directors approved amendments to our certificate of incorporation that would, among other things, create a new class of non-voting capital stock (Class C capital stock). The amendments authorized 3 billion shares of Class C capital stock and also increased the authorized shares of Class A common stock from 6 billion to 9 billion. The amendments are reflected in our Fourth Amended and Restated Certificate of Incorporation (New Charter), the adoption of which was approved by stockholders at our 2012 Annual Meeting of Stockholders held on June 21, 2012. In January 2014, our board of directors considered and approved a distribution of shares of the Class C capital stock as a dividend to our holders of Class A and Class B common stock (Dividend). The Dividend will have a record date of March 27, 2014 and a payment date of April 2, 2014. The Class C capital stock will have no voting rights, except as required by applicable law. Except as expressly provided in the New Charter, shares of Class C capital stock will have the same rights and privileges and rank equally, share ratably and be identical in all other respects to the shares of Class A common stock and Class B common stock as to all matters.

In accordance with the settlement of litigation involving the authorization to distribute the Class C capital stock, we may be obligated to make a payment to holders of the Class C stock if, on average, Class C trades below Class A in the first year following the Class C issuance, payable in cash, Class A stock, Class C stock, or a combination thereof, at the discretion of the Board of Directors. Because the Class C shares have not yet been issued or commenced trading, we cannot reliably predict what, if any, patterns will emerge over time with respect to the relative trading prices of Class A and Class C shares.

That does seem like a mouthful, but remember, companies are usually lengthy in their verbiage in financial statements. After Google's last earnings report, I included a discussion of what would happen in the event these new shares do trade at a discount. In that discussion, I took a piece out of an AP article that detailed the potential liability for Google should this distribution not go as well as planned. Here is the key piece:

Google will have to pay the Class C shareholders if the average price of their stock is at least 1 percent below the Class A shares during the first year after the split. The size of the payments will escalate as the gap widens, with the maximum payout required if the gap between the average prices of the Class C and Class A shares is 5 percent or more.

In the most expensive scenario for Google, Class C stockholders will get 5 percent of the average trading price of the Class A shares. So if the Class A stock has an average trading price of $600 during the first year after the split while the Class C stock averages $565, Google would have to pay $30 per share in cash or additional stock.

So investors will need to watch how those "C" shares trade. If they do end up trading at a discount, Google is on the hook for a large chunk of change. Google had more than $58 billion in cash and investments on the balance sheet at the end of 2013, so unless the payment is in the tens of billions, I don't see it being a problem. If Google is required to make a payment, I think that Google would probably just distribute more shares, because this isn't a company worried about a rising share count. Google isn't buying back stock like Apple, so the share count is already rising each quarter.

Why is Google doing this?

As the AP article states, this was a move engineered to ensure that Google co-founders Larry Page and Sergey Brin remain in control of the company. Page and Brin primarily own Class B shares, which contain 10 times as much voting power as Class A shares. The new Class C shares will not have any voting power. The AP article states that Page and Brin control about 56% of shareholder votes, despite owning less than 15% of stock issued. As Google pays executives and uses stock for acquisitions, the control for Page and Brin decreases. Google can now use the Class C non-voting shares for these purposes, keeping Brin and Page in control longer.

Another reason that this works for Google is that it should allow more investors to invest in the technology giant. At more than $1,200 a share, Google is expensive. Investors looking to invest $1,000 in a stock can't even buy one share. For investors looking to buy a set dollar amount, a $1,200 buy price may get them some shares, but leave a large amount of cash left over. By essentially splitting 2 for 1, the share price would go down to a little more than $600. The investor with $1,000 could then buy a share and have money left over. Investors with larger allocations will be able to gain more shares and get closer to their target dollar value.

This could impact Apple, good or bad:

While some may not see Google and Apple as competitors, the market caps of these two names have gotten closer recently. So these names are battling for investor dollars at the moment. Google closed Tuesday with a $408 billion market cap and Apple's was at $474 billion. The two of these names have large weights in many technology and overall market ETFs. For instance, the Technology Select Sector SPDR (NYSEARCA:XLK), which has Apple and Google as its two largest holdings.

So why is this split important for Apple? Well, for those that don't want to pay $1,200 plus for a share of Google, a share at $600 might seem more reasonable. Since Google is the higher growth company right now, you could easily see investors flee out of Apple into Google. Apple has a growth problem right now, and since Google shares will appear cheaper at $600, investors might flock to Google even more than they have been recently. In the worst case scenario for Apple, the split causes a rally in Google that pushes Google's market cap above that of Apple. In that case, many ETFs would be forced to sell Apple and buy Google as well. That's a big negative for Apple.

However, the flip side of this argument is good for Apple. Should the split not go well, and Google sell off, you probably would see a rush to shares of Apple. If Google is declining, ETFs will be forced to reduce their Google exposure, meaning the largest share of sale proceeds could go to the largest holding, Apple. One way or another, this split will have an impact on Apple. The size of that impact is to be determined. A number of technology ETFs, and many large cap ETFs, will also be affected.

Why this is big for the market in general:

There are two market items that are in play. First, how will indexes account for this distribution? Right now, Standard & Poor's is actually asking investors to provide their thoughts on how this distribution should be handled. The initial plan was to include both A and C shares in various indexes, but after June 20th to only use the C shares. As the above linked Reuters article states, that could create a large problem:

But portfolio managers who track those indexes, which is normally a tax-efficient strategy, complained to S&P DJI that this would force them to replace A shares with C shares, and by selling the A shares pass on capital gains to investors. They also objected to the loss of voting rights from selling the A shares, according to a letter to index investors and index fund managers from S&P DJI.

Investors can actually contact S&P until March 10th with their comments. It will be interesting to see how this is all handled in the end. My guess is that both classes of shares will need to be in each index, but that's just a guess right now.

The other market impact is whether or not this distribution works. If Google's plan works and the C shares don't have any problems, you may start to see more companies that already have different classes of shares and voting rights do this. Or, companies may create new classes of shares for this purpose. If executives are trying to protect their interests, this is certainly a good way to do it.

Final thoughts:

Google's biggest challenge yet may be the upcoming execution of the stock distribution. Investors are worried about Class C shares trading at a huge discount, and those lawsuits held up this process for quite a while. If this event goes well, look for other companies to do this, and look for Google's market cap to get even closer to that of Apple. I could see investors selling more Apple and buying Google because of Google's potential growth and lower priced shares. This process will also be closely watched because of the large impact on many indexes and ETFs. The downside here is that if this goes wrong, I could see how the PR disaster could be worse than the one we saw with Facebook's (NASDAQ:FB) IPO, given Google's current size.

So what should Google investors do? Well, the market likes Google right now due to its growth story, and I don't see how that will change anytime soon. The average price target on the street right now is $1,318, implying more than $100 of upside from here. I wouldn't be surprised if shares go higher after the distribution. I think market participants will try to protect Google here and make sure that nothing goes wrong, cause I don't think the market wants another PR disaster that will chase off investors. With earnings season more than a month off, this may be Google's biggest challenge at the moment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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