- Google's non-core assets including Google Fiber and Nest have become a big part of the company.
- These businesses, however, continue losing a lot of money.
- What role can Google's non-core assets play as investors look forward to the shares hitting $1,000?
Google's move to restructure the company as Alphabet Inc-C (NASDAQ:GOOG) to provide better transparency into its revenue segments including YouTube and Google Play, as well as its so-called moonshot projects, was well received by both Wall Street and the investing world. The restructuring is part of the reason why Google shares have made strong gains this year.
Google stock YTD Returns
But some Wall Street analysts don’t think that all the good gains have been made in Google. RBC’s Mark Mahaney still believes Alphabet’s restructuring could drive even higher multiples for Google, with shares reaching, and even exceeding, the $1,000/share mark based on a sum-of-the-parts basis.
Mr. Mahaney reckons that Google’s core (search, display ads, Google Apps, YouTube, Android, and Maps) has recorded a healthy 17%-23% Y/Y organic growth over the last three years. He estimates that Google’s core sports an operating margin of ~50%. Mahaney sees YouTube and Google Play, with estimated revenues of $7 billion and $4 billion in 2015, driving growth for Google core.
But it’s Mahaney’s second part of his bull thesis that’s worth pondering. Mahaney estimates that Nest and Google Fiber will soon become $1 billion businesses each, with other non-core assets including self-driving cars producing substantial value for Google. Mahaney sees Google losing $3 billion to $6 billion for its moonshot projects in 2015, but says that cost-cutting opportunities exist under new CEO Ruth Porat.
Google Non-Core Assets in Focus
The one thing that strikes you about Mahaney’s analysis is the kind of money Google is losing on its moonshot projects. The analyst’s $3B-$6B loss estimate for Google’s non-core assets appears to be well supported by Google’s latest earnings report. Google splits its revenue broadly into Advertising Revenue and Other Revenue. The Other Revenue is where Google’s non-core assets fall under. Google reported Ad Revenue of $16,781 million and Other Revenue of $1,894 million for the third quarter. Google’s non-core assets therefore contribute 10% to the company’s top line, suggesting that the group can no longer be treated as just another ancillary revenue line.
But looking at the bottom line is where things start to get interesting. Google splits its operating expenses under three categories: Traffic Acquisition Costs (TAC), Other Cost of Revenues, and Operating Expenses other than Cost of Revenue. Other Cost of Revenue is the expense category that accounts for expenditure on non-core assets. Google reported $3,471 million as the figure for Other Cost of Revenues. This implies that the company lost a hefty $1,577 million on its non-core assets, which works out to a staggering $6 billion annualized. Looked at in another way, Google’s non-core assets contribute 10% to its top line but account for a whole 25% of the company’s operating expenses.
One of the biggest reason why Google shares have performed so well this year is because the company has demonstrated an ability to cut costs and improve profitability. Specifically, Google’s traffic acquisition costs have slowed considerably thus allowing more ad dollars to trickle to Google’s bottom line. The company’s spending on its moonshot projects has also moderated. Investors have for long questioned the value of Google’s moonshot projects since they have been eating deeply into Google’s bottom line without, until recently, contributing tangibly to the company’s top line. Without its non-core assets, Google’s operating margin would improve from the current 25% to 37.5%, a massive 1250-basis point increase.
Luckily, Google’s non-core assets are growing--11% revenue growth over the last quarter. Google’s non-core businesses are maturing, which should result in lower losses and, hopefully, eventual profitability. Over the short-term, Google’s non-core assets are likely to have a bigger effect on Google’s bottom line through contracting losses. Google Fiber in particular appears very promising. Google Fiber offers superfast 1 gigabit upload and download service for just $70 per month, as well as a Basic Internet service after paying a $300 construction fee. Google is able to monetize the service not only through the monthly subscription fee, but also by facilitating faster and higher volume search.
Google Fiber has been well received, with some states even enacting laws to make it possible for more people to access the service. Google has been expanding reach of the service, and it could soon start contributing meaningfully to the company’s top line.
Google’s non-core assets are growing slower than the company’s core ad business, which means they are destined to remain a small part of Google’s revenue structure. The real opportunity for the segment lies in its ability to shrink its losses and allow Google’s profitability to improve. With assets such as Google Fiber enjoying good growth, this is a real opportunity for Google investors. As long as Google can continue lowering its costs and improving profitability, there is no reason to doubt Google stock price can hit $1,000 over the next 1-2 years.