Google Reports Rare Miss

Zacks

Google Inc’s (NasdaqGS:GOOG - News) fourth-quarter earnings of $8.22 missed the Zacks Consensus Estimate of $9.06, with revenues missing estimates by 9.7%. Shares were down 9.02% in after-hours trading.

Despite strong revenue growth across most geographies and stabilizing in Western Europe (except Germany), weak pricing and non-operating losses (the first time since the December 2009 quarter), resulted in the disappointing results.

Historically, Google has done much better than Yahoo Inc (NasdaqGS:YHOO - News), which has been struggling to hold its own and Microsoft Corp (NasdaqGS:MSFT - News), which has yet to gain critical mass. Google’s superior algorithms have consistently attracted more users and generated better conversions. 

Revenue

Google’s gross revenue touched a record $10.58 billion, representing sequential and year-over-year increases of 8.9% and 25.4%, respectively. Currency impact was neutral on a year-over-year basis and negative on a sequential basis.

Google is very strongly positioned in the mobile platform, where both smartphones and tablets have been making strong headway. The dominant position has enabled Google to generate very strong mobile revenue growth. In fact, the company’s position in mobile looks better than it was in traditional computing, which says something about its strategic planning and execution.

Additionally, Google continues to benefit from the secular shift in advertising spending from offline to online properties, increasing contribution from medium and small-sized advertisers, success of the DoubleClick ad exchange, improving search algorithms and better ad quality.

Revenues from both Google-owned and partner sites continued to grow double-digits on a year-over-year basis (they have grown double-digits each quarter over the last five years or so). Google websites accounted for around 69% of quarterly advertising revenue, while partner sites accounted for another 27%. Total advertising revenue was up 9.0% sequentially and 96.1% year over year. Google-owned sites were stronger than partner sites on a year-over-year basis.

Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was up 35.1% sequentially and 44.0% from last year. Moreover, traffic acquisition cost as a percentage of total advertising revenue was up 567 basis points (bps) sequentially and 397 bps from last year. Net advertising revenue, excluding traffic acquisition cost was flat sequentially and up 18.0% year over year.

Licensing and other fees brought in the remaining 4% of revenue in the last quarter, up 6.5% sequentially and 50.2% from the December 2010 quarter.

Total revenue excluding total traffic acquisition costs came in at $7.60 billion, missing the Consensus Estimate of $8.41 billion by 9.7%.

The U.S. generated around 52% of revenue, up 4.2% sequentially and 36.1% from a year ago. The U.K., with a 10% revenue share was up 1.0% sequentially and 20.7% from last year. Other markets accounted for the remaining 38% of revenue, representing sequential and year-over-year increases of 18.7% and 14.2%, respectively.

Google stated that Western European countries, such as the U.K., France and Italy stabilized, while Spain grew for the third straight quarter. However, Germany disappointed.  Emerging markets saw growth across all product lines, according to Google.

Margins

The gross margin of 65.0% was down 22 bps sequentially and 7 bps from the year-ago quarter. The gross margin performance was the combined effect of revenue growth, a 17% sequential (34% year-over-year) increase in the number of paid clicks, and a 8% sequential decline (also 8% year-over-year decline) in the cost per click.

The number of paid clicks and cost per click appears significant, as they are indicative of higher volumes coming at lower prices. The mobile and emerging markets businesses are growing strongly, which could be the reason.

Other costs, associated with data center operation, amortization of intangible assets, content acquisition and credit card processing increased from the year-ago quarter, increasing the pressure on the gross margin.

Operating expenses of $3.38 billion were higher than the previous quarter’s $3.28 billion. The operating margin was 33.1%, up 167 bps from the 31.5% recorded in the previous quarter and down 220 bps from last year. R&D as a percentage of sales declined both sequentially and year over year.

S&M expenses declined as a percentage of sales from the previous quarter, but was up from the year-ago quarter. Google has added a large number of people in recent quarters (1,100 in the last quarter). Other than fresh recruits, the company typically adds quite a few through acquisitions (it added Motorola Mobility in the September quarter).

Non-operating losses were $18 million, down from income of $302 million in the previous quarter and $160 million in the December 2010 quarter.

Google reported net income of $2.71 billion, or 25.6% of sales, compared to $2.73 billion, or 28.1% of sales in the September 2011 quarter and $2.54 billion, or 30.1% of sales in the year-ago quarter. GAAP earnings of $8.22 a share were down from $8.33 in the previous quarter and $7.81 in the December quarter of 2010. There were no special items in the last quarter.

Balance Sheet

Google has a solid balance sheet, with cash and short-term investments of nearly $44.6 billion, up $2.1 billion during the quarter. The company generated around $3.92 billion from operations in the last quarter and spent $951 million on capex, netting a free cash flow of $2.97 billion.

Our Take

Google generates revenue primarily from the sale of advertising space on its online properties. The company is therefore, focused on protecting and growing its position in the search market through continued innovation and quality improvements.

This focus has ensured that the company remains the dominant player in search, not just in the traditional computing segment, but even more so in the emerging mobile space. Google’s Android OS has gone a long way to cementing its position in mobile. Google has also made acquisitions over time that have augmented its in-house capabilities.

Google remains focused on growth through search, mobile, display and social. With the growing importance of social networking, Google introduced Google Plus. While some have commented that Google will not be as popular as Facebook, this is really not that much of a concern and remains to be proved.

In the meantime, it is obvious that social data will be an additional tool for Google, which has been making a number of acquisitions and innovations in the space. Management stated that social relevance in search was already resulting in better conversions, although data is naturally limited given the stage of the business. We feel optimistic about Google’s current efforts in social. 

Toward the end of last year, Google stepped up efforts targeting the small and medium business (NYSEArca:SMB - News) segment. The SMB segment has played a key role in elevating Google’s position in display and we expect the company to continue chipping away at Yahoo’s market share. Google’s success in display is very encouraging, since display advertising is expected to grow very strongly over the next few years, surpassing search advertising by 2015.

Despite the initiatives to drive growth and superb execution to date that have enabled the company to maintain share in a fast-growing market, the company is now seeing weak pricing, which could continue to impact results.  Additionally, Google shares have been range-bound, as investors remain concerned about legal matters and China.

China in particular has been a sore point, since the country’s Internet usage has been growing exponentially and local players such as Baidu (NasdaqGS:BIDU - News) and Sohu.com (NasdaqGS:SOHU - News) have been the main beneficiaries. The fact that they remain in government favor is also a point to consider.

Google shares carry a Zacks Rank of #3, implying a short-term Hold recommendation.

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