Making Sense of Google Inc’s Alphabet Soup

Last week Google (GOOG 0.37%) (GOOGL 0.35%) surprised the market with its announcement that the company will reorganize under the holding company "Alphabet." There are some obvious reasons for the change -- namely transparency and talent retention -- but there's more to the story. The Motley Fool's Vincent Shen and Dylan Lewis explain the restructuring and what it means for investors.

A full transcript follows the video.

Vincent Shen: We'll be running through our ABCs today, on this episode of technology Industry Focus.

Hello, Fools! This is Vince Shen coming to you from Alexandria, Virginia. I'm filling in for Sean today and I have Dylan Lewis with me. We'll be talking about Google's big reorg this week.

Dylan Lewis: Yes, we will. I heard you pause there for a second when you were saying what edition of the show it was. I know you were tempted to say "Consumer Goods". Habits die hard.

Shen: Yeah. We'll be talking about Google's Alphabet announcement today. For those of you that don't know, Google is going to be reorganizing under a new name: Alphabet. They're separating its money making businesses from its Moonshot ones. We'll be seeing the Google Ad and Internet properties being separated from some of their more tertiary businesses.

Lewis: This is huge news. I think this is probably the top headline for quite some time in business news in general. It's Google, after all, and it's a huge reorg for them. What's the management situation going to look like with some of the founders?

Shen: Larry Page is going to run Alphabet with Sergey Brin. The two of them are the co-founders. They will step up and run Alphabet. Sundar Pachai who had been the senior VP in charge of products will now be the CEO of Google. Like I said, that will encompass all the Internet products like Android, Search, YouTube, Apps, Maps, Ads, Gmail, etcetera.

In terms of a general breakout of what to expect for the subdivisions within the Alphabet, we have Google the search and Internet properties and then Google X which is some of their major technological advancements in that lab; Calico, which is healthcare and anti-aging research; Fiber, which is broadband, Internet, and cable; Google Ventures, which is their venture capital investment arm; Google Capital, which is capital investments and some late stage tech venture capital; and lastly Nest, which is smart home products.

Lewis: Okay. They'll be running those independently now under the umbrella of Alphabet. Do you know how they might have come around this name?

Shen: Yes. Larry Page posted on his blog and said "We like the name Alphabet because it means a collection of letters that represent language, one of humanities most important innovations, and it's the core of how we index Google Search. We also like that it means Alpha-bet (Alpha is the investment return above the benchmark which we strive for)."

I think that was a nice way to both be Google-y and be fun and culturally, and also appeal to investors a little with the announcement.

Lewis: Sure. A play on words. I'm kind of surprised. I thought they might make Google the parent company and have everything beneath that. I guess they're going with a whole new name.

Shen: I think the naming convention is to make it clear that Google Search is a subsidiary. All of the Internet properties are their own thing.

Lewis: Oh, OK.

Shen: They're stand-alone. I think it was just a point of differentiation for them. Looking into some of the reasons for the change, Larry Page also wrote in his blog post "We are not intending for this to be a big consumer brand with related products. The whole point is that Alphabet Companies should have independence and develop their own brands."

You want to look at some of the major reasons for this breakdown. I think part of it is that it's more sensible in terms of managing the current portfolio of projects that they're working on. You look at some of the Internet property stuff they do and some of their Moonshot healthcare stuff, and they're totally unconnected.

In a lot of ways it makes sense to have management teams setup that can specialize in that and are less tethered to the Google Search thing. They're independent so they'll run them as independent.

Lewis: That's great. I think it will give investors some relief to because the Google Search business will be much more stable, cash cow kind of business. It's going to be very different. Some of those Moonshots that you mentioned, having that clarity between the segments is very important.

Shen: Within this breakdown I think each independent company is given a little more autonomy. They can give each operating division a bit more leeway in their decision making in some of their business decisions.

I think another big thing that they kind of hinted at with their blog post is, it's a big step for talent retention. One of the things they said in the announcement was that it offers them the opportunity to reach management scale.

You look at someone like Sundar Pachai who has been at the company for 10 or 11 years and he goes from being a product manager to being an executive. Within the Silicon Valley realm that's a big ego boost, and a big way to keep someone at a company. There's so much poaching going on in the tech world that it's huge for them in terms of talent management.

Lewis: Absolutely. Some of the other big things I think motivated the change; I think it's a push toward transparency. You look at a holding company type structure, you can expect in the 4^th quarter of this year to start seeing financial breakouts along the holding company style. You might have to wait a while. I don't think it will be coming this quarter, but the next one.

We'll be able to see the results for Google specifically broken out and I think in the past it's been this guessing game. We've know 90% of money coming in was through ad revenue, but with separating out Google's core business from these separate ones, I think you can eliminate some of the uncertainty about the stability of their cash cow.

Lastly, I think this is something I just caught earlier today; there is a liability aspect of this. As independent subsidiaries, each major segment is shielded from the other ones. If something went wrong with one of Google's Moonshot projects or something, there is some shielding there. That's always nice to have if you're operating a multi-billion dollar business.

Shen: Okay. That makes a lot of sense. Before we move on to the second part of our discussion I want to make our listeners aware of a special offer. If you found this discussion informative, and interesting, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter service started more than 10 years ago by Motley Fool co-founders Tom and David Gardner.

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For the second part of the discussion I think we should take it down to the investor level to see what kind of impact this has for people who are current Google shareholders, or perspective shareholders. What do you think?

Lewis: Google had a nice stock pop immediately following the announcement. I think it was a little over 5% earlier this week. They've sustained some of that, too. I think the market was obviously happy about this and I think to a certain extent that goes back to what I was talking about before with transparency.

This reminds me a lot of what we saw after Amazon (AMZN -1.14%) decided to break out its AWS segment. Potentially, you have these very lucrative businesses running in the background for a while, people want insight into exactly what's going on with them. Once they get that signal that is going to happen I think there's a lot of enthusiasm in the market.

In terms of some of the mechanics behind what's going on, all shares of Google will automatically convert to the same number of shares of Alphabet, and they will have all of the same rights. The two classes of shares will continue to trade on the NASDAQ as GOOGL and GOOG. There's no disruption there in terms of looking up your tickers.

One of the funniest things about this is, you think of Google as this huge tech company and their footprint is massive; but with this name change, the properties for Alphabet.com and Twitter were not owned by Google. Alphabet.com is actually a BMW property.

Shen: Oh, wow!

Lewis: That's funny. I tried to visit it today and it was timing out. They've gotten absolutely inundated with traffic. If you are looking for more information in the coming months you can go to abc.xyz -- that's where they're hosting all of that. That is the umbrella company website.

Shen: Okay. I guess that makes sense. At this point in time, pretty much any social media handle that you can think of, and all the good URLs are already taken. I'm sure they'll probably try to fatten some people's wallets to take over those.

Lewis: Yeah. We were talking the other day about how blown away we were that one of our writers had the Twitter handle @Markets. You're always blown away when you see someone who has something so simple.

Shen: He must have been a pretty early member for Twitter in order to get that because now it has to have some crazy combination of numbers or something to get it.

With this reorganization, to try to help investors understand it better; is it possible for us to compare this any other company out there that might be operating under a similar structure?

Lewis: Yeah. A lot of major outlets have drawn a parallel with Warren Buffett's Berkshire Hathaway (BRK.A 0.64%) (BRK-B). I think part of that is that Larry Page has cited Berkshire as a model in the past. It's come up in conference calls and some of his public statements. I think there are some similarities there.

Both firms are pretty low on their debt load. They generate a ton of cash, neither has ever paid out dividends, or bought back shares, and they both have two share classes which ensures founders maintain control of the company. There's some financial flexibility and autonomy, like we talked about before, that comes with this structure that allows both of them to make long term bets, make big acquisitions; things like that.

I think there are some major differences that people are overlooking. While Alphabet's businesses operate independently, they are not going to be financially independent. You have to remember that 90% of Google's revenue comes from its ad revenue. That is still largely going to be what drives all of the capital allocation.

Something we were talking about before the show is, historically they've maintained a ratio of 70% allocated toward core businesses, about 20% to adjacent businesses -- things that are related to Internet, but not directly tied to the search properties -- and then 10% to more of these Moonshot type projects.

One of things that will be interesting is to know if they're going to maintain that balance moving forward. I'm guessing they will because it's worked in the past, but it will be interesting to see if they have to alter that a bit now that they're providing more transparency with their financial reporting.

One of the other major differences between what we're seeing with Google Alphabet and the parallel of Berkshire Hathaway is the underlying businesses are very different. Google is very heavily invested in the speculative money losers that could pan out and be Moonshot projects down the road in terms of these huge revenue drivers.

Berkshire has this near-pathological obsession with value investments. They are looking for things that are undervalued and that they know they can capitalize on. Fundamentally, the business approaches are very different. Structurally, there are a ton of similarities. I wouldn't go so far to say that Google is becoming like the Berkshire of tech.

Shen: I still think it's a really interesting comparison, but yes. Some of those fundamental differences an ideology MOs; I wouldn't say they're pairing up too much.

Thank you very much, Dylan. Great discussion. I think this is a very cool topic. There's a lot of different layers for people to explore who are interested in investing, or those that are current shareholders.

Otherwise to close out, as always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. Thanks for listening, and Fool on!