Alphabet Inc. Nest Has Been Disappointing But All Hope Is Not Lost

  • Google bought Nest Labs in 2014 but the investment has failed to meet revenue targets.
  • Google might decide to sell Nest Labs when the initial merger agreement ends later this year.
  • Google's bottom line is likely to see considerable improvements once the company starts cutting off its unprofitable investments.
When Google, now Alphabet Inc-C (NASDAQ:GOOG) paid over $3.2B for Nest Labs in 2014, the move appeared to be a strategic, albeit expensive, one. After all, tech giants including Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) were both embroiled in their own smart home ambitions and Google risked being left behind. Nest Labs is best known for its Nest Protect smoke alarm and Nest thermostat which at the time appeared to have good potential to become home-runs.

But alas, two years down the line Nest Labs has not turned out exactly the way Google and its investors would have hoped for. And, it's beginning to increasingly look like Google might have to write-off Nest as just another bad investment. The business brought in just $340M in revenue for Google in 2015, and that is after you include revenue from Dropcam, which Nest acquired for $555M just months after the merger with Google. When you back out revenue from Dropcam, which has turned out to be yet another bad investment, Nest Labs failed to hit the $300M revenue target that Google had set for the business for 2015.

Part of the agreement when Google was negotiating terms for the merger with Nest Labs stipulated that Google would continue to support Nest with an annual operating budget of ~$500M and in return Nest would ensure that its key engineers and executives stayed onboard. The deal was set to last three years which means it will run out at the end of the current year. After that all bets are off regarding whether Google will agree to continue supporting Nest Labs or whether it will let the investment run itself to the ground.

All Hope Is Not Lost

Nest Labs happens to be one of Google's major non-core assets, the others being Verily (formerly Google Life Sciences), Google Fiber, and self-drive cars. There are a couple of reasons advanced by observers to explain the dismal performance of Nest Labs with much blame being apportioned to Nest CEO Tony Fadell and his abrasive leadership style. Google investors have long blamed the company's heavy investments in the so-called moonshot projects for putting a lot of pressure on the company's bottom line. In fact, one of the reasons why Google restructured the company under core Google and Alphabet was to give better transparency into these new businesses as well as shed more light into non-search ad businesses such as YouTube and Google Play.

Google reports results for its moonshot projects under the ''Other Bets'' segment. Google reported that Other Bets brought in revenue of just $448M in 2015, which is actually much less than what many analysts and investors previously thought. Obviously many of these businesses are still at their infancy without much revenue to speak off. In fact only Nest, Fiber and Verily brought any kind of revenue for Google in 2015. Even with Google's improved reporting, businesses such as Verily are still shrouded in mystery and it's hard to come across any estimates regarding their respective revenues. All that is known of Verily is that it has so far managed to cut seven deals with medical companies since its inception in 2013 by Google.

Google Fiber has managed to break ground in at 18 cities with plans to roll out the service in many more cities. Many analysts see Fiber as having good revenue potential, but it is gobbling up huge amounts of infrastructure capex.

Google is considered one of the early leaders in self-driving cars, and its autonomous cars have logged in millions of miles so far in actual road tests. Google cars have a pretty good safety track record and it's only recently that one of its vehicles was involved in a serious accident implying the vehicles are much safer than human-driven cars. Nevertheless the reality is that it will probably take not less than 5-7 years before appropriate legislation is enacted to make autonomous cars a reality on U.S. roads.

So despite the disappointing performance by Nest Labs, some of Google's moonshot projects appear quite promising

Investors are probably not as interested in the individual performance of Google's moonshot projects as they are in the kind of impact these businesses have on the company's bottom line. The 'other bets' segment reported an operating loss of ($3,567M) in 2015 compared to an operating profit of $23,425M for core-Google (Google Still Gives The Best ROIs In Online Marketing, its core business). The loss was 84% higher compared to the previous year.

Investors will probably be wishing that Google jettisons duds like Nest Labs that have been weighing heavily on the company's profits but do not appear likely to go anywhere. While investors will appreciate the revenue contribution from these businesses, the real opportunities lie in cutting their costs and easing the pressure on the company's bottom line. If Google starts selling its unprofitable bets, then it could do wonders for the company's profits and for Google stock as well.

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