There's a good financial case for an Alphabet breakup, and a trillion dollars at stake
- Presidential candidates like Bernie Sanders have campaigned on breaking up technology giants like Alphabet, the parent company of Google, whose market value is more than $1 trillion.
- State attorneys general are working on antitrust reviews and coordinating with the Department of Justice.
- Recent revenue reports for YouTube and its cloud business shed light on the financial implications of asset spin-offs.
Presidential candidates like Sens. Bernie Sanders and Elizabeth Warren have campaigned on breaking up technology giants like Alphabet, the parent company of Google, whose market value is more than $1 trillion. The idea is that owning a big collections of tech assets — in Alphabet's case Google's search business, YouTube and a fast-growing cloud computing business — made the company too powerful.
But could the market entice Alphabet to beat regulators to the punch? Unprecedented disclosures about the size and growth rate of its different divisions, including YouTube and Google Cloud Services, offered by Alphabet as part of its recent earnings, gave markets the first clear shot at valuing what the sum of its major pieces might be worth if spun off as separate companies. Meanwhile, state attorneys general are working on antitrust reviews of Google and coordinating with the Department of Justice. The Federal Trade Commission is planning to investigate many acquisitions made by Alphabet, Apple, Amazon, Microsoft and Facebook.
Analyzing a potential breakup, forced by Washington or otherwise, begins with assessing what the three big companies that would be formed — Google Search, YouTube and Google Cloud — are likely to be worth, based on the market values of their nearest rivals.
The estimates, calculated by CNBC with input from Wall Street analysts, suggest that Alphabet's three biggest businesses alone are worth about as much as the entire company's $1.04 trillion public valuation now. That excludes more than $100 billion in cash, and a collection of businesses with $14 billion in 2019 revenue described in company filings as "Google Other" businesses. These include the Google Play music service and app store, and Google-branded hardware such as the Pixelbook laptop. In all, the analysis points to a potentially significant undervaluation of the entire company relative to its pieces, said John Freeman, who follows Google for CFRA Research.
"Some analysts claim Google would be worth more broken up, and they're roughly right," CFRA Research analyst John Freeman said in an interview. "You do lose some synergies, but these businesses operate fairly independently."
Alphabet itself has not said anything about splitting itself up or making any major strategic changes. It did not respond to requests for comment.
Google search vs. Facebook
The largest, and still most valuable, would be the Google search business, RBC Capital Mark Mahaney said. The simplest way to value it, since Alphabet has so far broken out the sales of each business but only aggregate data about their profitability, is to compare its size and growth rate to that of Facebook, Google's only close rival in the online advertising market.
Facebook is expected to post $85.7 billion of sales this year, up 21%, according to the average of 50 analysts surveyed by Thomson Reuters. At a market cap of $540 billion after adjusting for cash holdings, that works out to about 6.3 times sales.
So by that crude rule, Google's search-dominated core advertising business, which had $98.1 billion in 2019 sales, according to the company's 10-K, is worth about $710 billion, or 70% of the company's $1.05 trillion market value, Freeman said. A small discount from Facebook's valuation is probably appropriate because Facebook's advertising sales are growing faster than Alphabet's, Mahaney said.
YouTube vs. Netflix
Google disclosed that YouTube had $15.1 billion in 2019 advertising sales, up 36% from a year ago.
The leading independent comparable for YouTube would be Netflix, the other big player in streaming video. Netflix has a very different business model, since it makes money on subscriptions rather than ad sales. But YouTube's fourth quarter saw the service reach a $3 billion run rate for its own subscriptions, putting total YouTube revenue at a little more than $18 billion. That's likely to grow more this year, putting annual revenue from YouTube around $23 billion if growth slows to 30% or slightly less.
Netflix trades at 6.8 times its expected 2020 sales, so a $23 billion revenue-generating YouTube would be worth about $156 billion, Mahaney said.
"There are a lot of programming costs at Netflix, but it's a way to begin to think about valuing YouTube," Mahaney added.
Google Cloud vs. Microsoft Azure, Amazon Web Services
Then there's the cloud business, which grew more than 50% last year, to $8.9 billion in sales, exiting the year with a $10 billion run rate, according to Alphabet. The trick in valuing the cloud business is that neither of its main, and much bigger rivals — Microsoft's Azure business or Amazon Web Services — is independently traded.
Mahaney has used 10 times sales as a working guide to valuing AWS. That could put Google Cloud Services at around another $150 billion by mid- to late 2020, as its growth pace for the year comes into focus.
"I think they're going to take significant share,'' in cloud computing, Freeman said, partly because Alphabet's research on artificial intelligence will let them distinguish their offerings from rivals. "The rankings — Amazon, Microsoft, Google — won't change, but Google Cloud will get its share.''
What about profits?
Google doesn't yet disclose profits or losses at Google Cloud or YouTube. But analysts point to the 26% operating margins at Amazon Web Services as a medium-term goal for that business, and say the low programming costs of YouTube can give it a head start toward matching or outdoing Netflix's profitability.
Google search is a high-margin cash machine that helps pay for a lot of the other bets and smaller businesses that generate so much of Alphabet's potential to boost its value well past even today's $1 trillion, Freeman said. Profits from search, having nurtured YouTube back when it had little to no revenue, are now paying for efforts in quantum computing, artificial intelligence and other areas that could lead the way to autonomous vehicles and other breakthroughs, he said.
YouTube could become more profitable than Netflix, which earned $1.87 billion last year, because its mostly user-generated content doesn't lead to high programming costs, Freeman said. It also has untapped potential because its average revenue per user is much lower than at Netflix or other major web-ad players. Indeed, Morgan Stanley analyst Brian Nowak pointed out in a report that YouTube converts viewers' time and attention into money less efficiently than Google search.
It's unclear what kind of profit, if any, Google Cloud generates today, but the cloud businesses at Alphabet's main competitors, Amazon and Microsoft, have seen profitability ramp up sharply as they grow larger. Microsoft's commercial cloud business, dominated by Azure, increased its gross margins by 5 percentage points in the second half of 2019, and Azure revenue grew by 62% in the company's recently reported fiscal second quarter.
The worst thing that could happen is if the government regulates what kind of advertising algorithms they can use.John FreemanCFRA Research analyst
So, boiling down the numbers, Google's core ad business, YouTube and the Cloud unit would independently be worth about what the entire company is now.
That suggests the market either undervalues those businesses or assigns little to no value to Google's cash pile of $115 billion, net of debt. It also assigns no value to Google's money-losing Other Bets unit, where it houses many of its research-and-development units; nor to Google Play, hardware, and other operating businesses that generated $14 billion in revenue in 2019 (that excludes $3 billion in YouTube subscriptions which the 10-K lists in this category, but analyst estimates accounted for as part of YouTube's stand-alone value).
"You don't have to be a genius to know some of them are going to be large businesses," Freeman said.
Some other smaller businesses, including technology think tank Jigsaw, smart-home device company Nest, and cybersecurity firm Chronicle, have been reabsorbed by Google.
For now the main financial strategy Alphabet has disclosed is ramping up share repurchases, which boosts earnings per share by using available cash to reduce the number of shares. Google repurchased $6.1 billion of stock in the fourth quarter, twice as much as a year earlier but still at an annual rate of about 2% of the company's value. The company still pays no dividend on its common stock, despite generating more than $30 billion in free cash flow last year.
"As of year end, we had $21 billion remaining in the program and are focused on executing on the remaining authorization at a pace that is at least consistent with what you saw in the fourth quarter," Alphabet chief financial officer Ruth Porat told analysts on Feb. 3.
Wall Street doesn't expect Google to break itself up at a time when it's spending $25 billion a year on capital projects and another $26 billion a year on research and development, Freeman said. But the numbers also make analysts comfortable that shareholders will likely do fine if Washington does insist that the company split itself into its major parts, he added.
"I don't think they're scared of [Washington forcing a breakup]," Freeman said. "The worst thing that could happen is if the government regulates what kind of advertising algorithms they can use.''