What Google's 'Split' Means For Investors

| About: Alphabet Inc. (GOOG)

Google (GOOG) announced last week that it would have an "effective stock split" via "a new class of stock." Investors have been clamoring for stock splits from Google and Apple (AAPL) for quite some time as the share prices quickly accelerated into the mid-triple digits and the cash balances ballooned. Apple responded by reinitiating the dividend and announcing a share repurchase plan rather than a split.

Investopedia provides a brief overview of why companies initiate stock splits but Google's split is unorthodox because the company seeks to maintain the founders consolidated voting rights. Public opinion regarding Apple's decision was generally positive as shareholders receive a tangible benefit in the form of a cash payment and EPS improvement. On the other hand, Google shareholders are left scratching their heads wondering exactly what their benefit is.

(Source: Yahoo! Finance)

From the press release:

Today we announced plans to create a new class of non-voting capital stock, which will be listed on NASDAQ. These shares will be distributed via a stock dividend to all existing stockholders: the owner of each existing share will receive one new share of the non-voting stock, giving investors twice the number of shares they had before. It's effectively a two-for-one stock split-something many of our investors have long asked us for. These non-voting shares will be available for corporate uses, like equity-based employee compensation, that might otherwise dilute our governance structure.

The stock dividend we are announcing today will have the basic effect of a two-for-one stock split. Each holder of a share of Class A or Class B common stock will receive one share of the new non-voting Class C capital stock. So after the dividend, a stockholder who currently owns one Class A share with a single vote will continue to own that share plus one Class C share without a vote.

The Class A shares will continue to trade under the "GOOG" ticker symbol, while the Class C shares will trade under a different ticker symbol, so stockholders will be able to trade these shares, just as they can with Class A shares today. Except for voting rights, the Class C shares will have the same rights as the existing Class A and Class B shares. As is typically the case with stock splits, the Class C stock dividend will be tax-free.

There are numerous complications with this "transaction" for current Google shareholders. It is true that stock splits are generally value-neutral as value is neither created nor destroyed. There are typically qualitative benefits to splits such as the illusion of affordability and increased access to options due to lower minimum investments. Google's synthetic split does have those benefits but I believe reduces shareholder value. Below I will present an example:

If I own 100 shares of GOOG-A at $600 I will end up with 100 shares of GOOG-A at $300 and 100 shares of GOOG-C at some amount less than $300 because of the lack of voting rights. One could argue that the class A shares essentially do not have voting rights because the founders control the voting majority. In such a case the class A and C shares would trade for the exact same amounts.

The current consensus from my research is that the non-voting shares are less valuable to institutional investors in the long term as the voting right does have some value. As a consequence, the non-voting shares should trade at a discount to their voting sibling shares. Furthermore, it is very likely that the S&P 500 will essentially ignore the GOOG-C for indexing.

Per a J.P. Morgan research note,

Standard & Poor's will probably follow its standard practice of using only one of the shares as the 'representing class' for indexing purposes. Other indices, such as the Russell, and the Nasdaq 100, will likely follow suit… The end result of all this, suggests Moon [JPM Analyst], is that investors may sell 41 million shares of Class C to buy the Class A shares.

In theory investors should not face a steep loss in value as the declines in GOOG-C will be offset by gains in GOOG-A but only time will tell. Google investors are already in the red as the stock has dropped over six percent from Thursday's closing price.

One has to wonder if this split was at least partially motivated by Apple's share price surpassing Google's price but that is just pure conjecture. There is no escaping the comparisons as the two companies increasingly compete on more fronts. Just a few years ago it was hubris to suggest that Apple would pass Google's share price when the two companies had the same market cap. As a nostalgic look back, Apple was trading below $160 at that point.

Who could have guessed that Apple would surge over $400 in that short period of time? The two companies have maintained a fragile alliance as Google derives the vast majority of its mobile revenue from iOS devices. Both companies have been very successful with different strategies but Apple has simply grown at an unprecedented rate for its size.

In closing, I cannot claim ignorance because Google did make it abundantly clear that it "is not a conventional company" in its unique owner's manual for shareholders. Google is notoriously for running afoul of corporate governance activists for its corporate structure but investors were able to palate this because the returns were far in excess of the S&P 500 for the early part of its public existence. Google's failure to significantly outperform the market has raised attention to these peripheral aspects of the company.

I have been long Google for over five years and am starting to question my investment for the first time. Make no mistake, Google is a great company (not just good) but investors have not been rewarded for their patience with the company. Tiernan Ray summarized the transaction succinctly in Barron's this weekend:

This latest communiqué reinforces some aspects of Google that are distinctly shareholder unfriendly. It's not a catastrophic development for the company, but it may be one more thing holding back the shares."

Disclosure: I am long AAPL, GOOG.

Additional disclosure: Author is long AAPL, GOOG, AAPL May 19 2012 700.0 Calls, and AAPL Jul 21 2012 620.0 Calls