Fri, 7 Feb 2014
Although the Motorola sale and proposed stock split aren't the best for shareholders, the Internet giant has a very wide moat and excellent management, says StockInvestor editor Matt Coffina.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. There's been a lot of news on Google recently, but should investors be worried about what's going in Mountain View, Calif.? I'm here with Matt Coffina--he is editor of Morningstar StockInvestor--to take a look at some of the company's recent moves.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start with one of the big announcements that Google is selling Lenovo its Motorola handset business. At first glance, it seems like they're taking a big loss, and they're selling it for less than $3 billion. They bought it for more than $12 billion just a few years ago. Was this just a complete destruction of shareholder capital by Google or is there more going on here?
Coffina: It doesn't look quite as bad as it seems on the surface. Google did buy this business for about $12 billion, but there were some other offsets. They sold Motorola's set-top box business already. There was also lot of cash on the balance sheet in Motorola at the time of acquisition. There was some tax-loss carryforwards, but Google also accumulated some losses in the time that they owned Motorola.
All in, I estimate that the loss is about $6 billion, and you could attribute this to the patents that Google is retaining, more than 10,000 patents that Google is going to hold on to, and the value of those patents is mostly for defensive purposes, as Google is going to have to defend its Android ecosystem and its intellectual property against the competitive assaults of Microsoft, Apple, and other companies like that. It's going to help Google to have those patents on hand. That price is not far from where they estimated the value of the patents at the time of acquisition. So, maybe a little bit on the rich side, but the loss isn't as bad as it seems on the surface.
Glaser: Does the fact that they did turn that around so quickly give you some pause about the capital allocation skills of the management team, or do you think that this was a savvy way to get out of a handset business that wasn't working for them?
Coffina: Yes. I mean, I think the whole experiment was clearly a failure. I think management hoped for a lot more out of the Moto X phone, in particular, the first flagship phone they launched under Google's leadership. I think they found that it was much harder to gain market share in the mature and very competitive handset business probably than they expected.
That said, I think when they acquired Motorola, everyone was really wondering about whether you had to own both the hardware and the software components of the mobile device to be successful, and I think Google has found over time that you don't really need to do both of those things. You don't need to follow the Apple model. They can just stick to the software and services side, and let other companies do the really competitive hard work of selling handsets.
So, it's an experiment that didn't go that well, but the financial costs to shareholders isn't that huge, and if anything, I'm glad that Google is realizing now that it was a mistake. Usually it's better to realize your mistakes quickly and move on rather than persist in it for a couple of years gathering more losses.
Glaser: The company is going to have a stock split, is also adding a new share class. What's behind these moves? Do you think they're shareholder-friendly?
Coffina: I definitely don't think it's shareholder-friendly. I'm actually quite disappointed with Google's management on this score. This had been delayed for a couple of years by a shareholder lawsuit. They've been discussing it for a couple of years, but basically what Google is going to do is they're going to split their Class A stock, which is the regular shares that everyone owns right now, and they're going to issue a new class of Class C shares. The Class B shares are owned by Google's founders, Sergey Brin and Larry Page, as well as Eric Schmidt, the executive chairman.
The Class B shares already carried 10 times the voting power of the Class A shares, and originally this was intended to ensure that management and the founders, in particular, remain in firm control of the company. But what's happened is, over time, Google has issued more and more Class A shares, in particular, to employees through employee stock compensation plans, but also in the future, they could potentially use the stock for acquisitions and management wants to make sure they're not going to get diluted by doing this.
The problem, I think, is not so much management staying in control. I think management has certainly earned our trust and done a phenomenal job executing at Google over time. I don't mind management staying in control, but there is really no reason that Google needs a Class C class of shares in order to make that happen. They have $60 billion, or close to $60 billion, on the balance sheet. Google generates some $10 billion of free cash flow every year, and none of that is used to either pay a dividend or repurchase shares.
What concerns me about this, I think, is that Google is basically setting themselves up to be able to do an unlimited amount of dilution in the future with basically no consequences for management in terms of dilution of their ownership right. I think it's OK for management to want to retain control, but they should be doing it by using some of their cash to repurchase Class A shares to prevent dilution in the first place, rather than admitting that basically they're never going to make good use of their cash and they're just going to keep diluting shareholders over time.
Glaser: Does this move give you pause in investing in Google? You mentioned that $60 billion of cash--allocating and investing that cash well is going to be a big driver of the value of the firm in the future. Does this make you rethink your thesis?
Coffina: Yes. We own Google in StockInvestor's Hare Portfolio, and I do expect to continue to own it despite the share split, and I think it should give you a pause and it's sort of a red flag about management. But that said, we knew going in that we weren't really going to have any control as minority shareholders. We knew that management had complete discretion to do whatever it wants.
Furthermore, Google is not alone. A lot of these tech companies have very poor capital allocation policies historically. In some cases those are improving. We see Intel pays a generous dividend now. Cisco pays a generous dividend. It's using its cash more wisely. Microsoft as well. But it seems that these companies need to be very, very mature and arguably on the declining side of things before they get serious about being disciplined with their cash.
Google obviously doesn't think it's there and doesn't think it needs to use the cash to provide or return to shareholders. But I'd hate to think where that share price would be if this whole time they had been purchasing stock. You could say the same thing for Apple. With all the cash flow these companies generate, if they had been purchasing stock over this time, I think the share prices would be a lot higher than where they are, and I think we should be a little peeved at management for that.
Glaser: Looking past some of these corporate governance issues and these allocation issues, are you happy with how management is running Google and how the results have looked?
Coffina: That's really the offsetting factor, and why I'm willing to continue holding Google is that the company is just performing phenomenally, especially for a company its size. It's still growing revenue somewhere in the neighborhood of 20% on the core Google website's advertising businesses, search advertising, YouTube, and that sort of thing. So, it's a very, very strong franchise, a very wide moat. Management has executed very well over time, including a lot of products that people probably thought were crazy at the time. Things like Android, the YouTube acquisition, and so on.
Overall I think management is doing a great job of running the business. I just think that Google could be doing a lot better with its capital allocation policies.
Glaser: Matt, thanks for your thoughts on Google today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
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