Google’s announcement that it was forming a new parent company called Alphabet Holdings has triggered several price target increases, including a new one from Citi just this week. The main benefit of the creation of that company is that it should provide more transparency into Google’s finances. The other benefit is that it will separate the money-making machine that is Google’s digital ad business from the money-pit that includes the company’s more experimental inventions.
Google price target to $781
In a report dated Sept. 24, analyst Mark May said he increased his price target for Google from $730 to $781 per share. He maintained his Buy rating on the stock. Google shares have appreciated meaningfully since the announcement about Alphabet. May created this diagram to help investors picture what the new company will look like:
Google is expected to start reporting under the new structure starting with its January report.
Core Google versus Moonshots
Google calls its inventive division Moonshots, as many of the products being worked on in the segment probably won’t ever land on the consumer market. May analyzed Google’s two main parts, which include the Moonshot division and the Core advertising division.
He said the company spends about $4.5 billion on its Moonshots per year, and he thinks consensus estimates for the 2016 calendar year and beyond seem to reflect this estimate.
He estimates Core EBITDA margins at about 55%, compared to the 50% Google reported in the second quarter. He used a sum-of-the-parts methodology, which doesn’t give much value to the Moonshots division:
These estimates assign a value to Google as a whole as $781 per share.
Breaking down Google’s non-Moonshots expenses
The problem some investors have with Google is how much the company spends on its Moonshots projects and how little revenue it receives in return. In order to figure out how much the company spends on Moonshots, May estimated the non-Moonshot expenses. He used 2009 numbers because that was the last year when advertising revenue made up the vast majority of Google’s overall revenue:
For Google Play, the analyst says GAAP revenue is net of the 70% revenue sharing from gross bookings it pays to developers, but that’s before the revenue share paid to wireless carriers. He believes Google is in in talks with developers for better revenue sharing agreements, which should increase profitability in the segment.
In licensing, he’s assuming a slight decline in licensing operating margins since 2009 as Google has probably seen a higher mix of licensing revenue for enterprise apps, which he thinks bring lower margins.
He believes Google’s hardware division operates at breakeven level or higher because management has talked in the past about the need to make the segment self-supporting rather than dragging on profitability from the rest of the business.
In addition to the Moonshot projects, Google has been heavily investing in its Cloud Platform, which the analyst seems to think is the biggest wild card in his estimates. He believes it to be “modestly profitable,” although he assigns a “significant margin discount” compared to Amazon Web Services because of the differences in size and operating leverage.
Estimating Moonshots expenses
After backing out these expenses, he estimates that Google’s expenses on its Moonshots projects has a compound annual growth rate of about 48% over three years. He thinks operating expenditures for the segment will fall year over year this year, noting that management has talked more about cost controls and that they have started to rationalize products like Google Glass.
With all these expenses, May believes Google’s Moonshots segment will drag on the company’s overall EBITDA this year by $3.3 billion:
As of this writing, Class A shares of Google were down 0.09% at $654.32 per share.
All charts in this article are courtesy Citi.
