The Problem With Google That No One Is Talking About

Jul.15.12 | About: Alphabet Inc. (GOOG)

Google (GOOG) stock has been a real disappointment so far in 2012, declining almost 11% at a time when the S&P 500 has increased 8% and the Technology sector (XLK) has increased 11%. Most of the damage occurred early in the year, when the company reported a soft Q4, with analysts reducing earnings estimates modestly for 2012 and 2013. Since then, the stock tried to recover after reporting a decent Q1, but it sits near the lows set in January as we await Q2 results:

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Not a pretty picture, with lower highs and lower lows, albeit slightly.

There are lots of reasons why GOOG hasn't performed well, many of which are being widely discussed. These include:

  • European exposure
  • Transition to mobile
  • Motorola integration

This week, there were several cautious broker comments around these topics in advance of their Q2 earnings report to be released after the close on Thursday, including Bernstein, Benchmark and ITG Research. Jim Cramer had a negative preview as well on Friday's Mad Money episode, citing the European exposure.

I don't have any particular insight into these issues. I think that the good news is that none of these concerns are exactly new - it's the same issues investors have been discussing for the past few quarters.

One issue, though, that I think is weighing on the stock and getting almost zero attention is the hare-brained "stock split" announced on April 12th when they reported Q1 results. The stock hasn't been the same since then.

Recall that the company stated in the press release that it the "Proposal Would Effectively Implement 2-for-1 Stock Split While Preserving Long-Term Governance Structure" The single paragraph stated:

Google announced today that its Board of Directors unanimously approved a stock dividend proposal designed to preserve the corporate structure that has allowed Google to remain focused on the long term. More information is available on our Investor Relations site, including a letter from our founders Larry Page and Sergey Brin explaining the proposal, and in our forthcoming proxy statement.

There hasn't been any sort of update by GOOG in terms of a press release, but the proposal did pass (no surprise given the current voting structure) at the annual meeting on June 12th despite 160mm shares voting against it. The company buried this little nugget in the most recent 8-K filing:

On June 22, 2012, Google filed the Fourth Amended and Restated Certificate of Incorporation with the Secretary of State of the State of Delaware. As previously reported, Google's recapitalization is the subject of pending litigation. Once this litigation has been resolved, Google expects its Board of Directors to consider the declaration of a dividend of one share of Class C capital stock for each share of Class A common stock and Class B common stock outstanding as of a record date to be determined at that time by the Board of Directors. Google cannot predict when the pending litigation will be resolved, but does not expect it to occur before the fourth quarter of 2012.

I have yet to see any analysis from Wall Street of the potential impact to the GOOG stock price from the change in share structure, but I think it's worth about 30 points off the price, perhaps more. Worse, it may be creating an additional overhang on the stock due to uncertainty.

How do I come up with 30 points? Here's the math. The new C shares will likely trade at a 10% discount. This means the value of the entire investment declines by 5%, which is roughly 30 points. GOOG will still be GOOG (but at half the price), but if you add GOOG/2 plus .9*GOOG/2, you get 0.95 GOOG. 5% of GOOG is roughly 30 points. Let me explain my thinking.

Each shareholder will receive one share of "C" stock for each A or B (supervoting) stock that he or she owns, making it effectively a 2-1 split. On one hand, there isn't a great difference between GOOG and the C shares with respect to control of the company or economics. On paper, C shares, which lack voting rights, could be deemed less valuable, but the GOOG shares don't have much benefit in terms of voting due to the presence of the B shares. Any future dividends would be the same for GOOG and the C shares. Ultimately, there is no difference.

On the other hand, there will likely be substantial liquidity differences between the two classes. I would expect GOOG will remain in the S&P 500, but the new C shares will not. There is also the issue of supply and demand - C shares will be in supply, whether for acquisitions or incentive compensation. From the proxy:

This new capital stock, which will be known as Class C capital stock, will be available for use for, among other things, stock-based acquisitions and equity-based employee compensation.

This is somewhat unprecedented due to the size of the company, but there are lots of examples of stocks with multiple classes. A great one? Discovery (DISCA), which has a similar assumption. DISCK, which is the non-voting stock, trades currently at an 8% discount, but it has narrowed greatly over the past two years. My assumption of a 10% discount is just an assumption, but I have reviewed several of these cases.

I am currently holding GOOG in my Top 20 Model Portfolio. We added the name in January after the plunge. As the name of the model suggests, we hold 20 securities. I will be forced to choose GOOG or the C shares. While most investment managers don't face such explicit requirements, the reality is that most will not want to hold two different stocks of the same company. I predict the initial response following the "split" will be a sell of the C shares, with perhaps some simultaneous buying of A. This will be exacerbated by index funds should C shares not be included in the S&P 500 or the Russell 1000. Ultimately, retail investors will likely gravitate to the C shares. The "C" will be said to stand for "cheap".

I believe that this pending transaction has likely put some additional pressure on GOOG. Some holders have likely sold with the hope of getting shares cheaper later, while other potential buyers have waited for the structure to be implemented. Of course, it's difficult to tell how much has been priced in. Clearly, the more important near-term catalyst for the stock will be the earnings report this week, but my guess is that sellers on strength could emerge, should there be strength, as the "split" looms ever closer. While I continue to hold the stock in my model, I have reduced my target by 5% to account for the change in the structure.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long GOOG in one or more models managed by the author at