CPCs Weighing on Google Shares

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Google Inc (GOOG) reported second-quarter earnings of $7.81 that missed the Zacks Consensus Estimate by $1.23, or 13.7%. Declining CPCs were the main reason for the miss and a growing hardware business also contributed. Shares were trending down during the day and lost another 4.14% after the company announced results.

Revenue

Google’s gross revenue came in at $14.10 billion, representing sequential and year-over-year growth of 1.0% and 19.5%, respectively. Google standalone revenue grew 1.2% sequentially and 19.5% year over year, but Motorola’s growth rates continued to lag.

Revenue from Google-owned sites grew 2.6% sequentially, while partner sites dropped 2.1% resulting in net growth of 1.3%. Management stated that initiatives to increase the protection of users were impacted growth at partner sites. Both segments continued to grow (17.6% and 7.0%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 63% and 23% of quarterly revenue, respectively.

Other revenue was flattish sequentially and up 138.3% year over year to a little over 7% of revenue. Management attributed the increase to higher Play Store sales (including hardware and ecommerce) but the very strong year-over-year growth was again partially attributable to the change in the Play app revenue recognition policy. App revenues are now being recorded on a gross basis, with carrier/OEM payments included in the cost of sales whereas previously, just the net amount was included in total revenues.

The Hardware and Other segment (Motorola) accounted for around 7% of revenue, down 2.0% sequentially and up 18.4% year over year. Management did not say much about Motorola’s future plans.

Total traffic acquisition cost, or TAC (the portion of revenue shared with Google’s partners and amounts paid to distribution partners and others who direct traffic to the Google website) was up 1.7% sequentially and 15.9% from the year-ago quarter (9 bps and 28 bps, respectively as a percentage of advertising revenue). However, while the increase in TAC related to AdSense arrangements is declining, distribution-related TAC is on the rise. This is significant, as it indicative of growing competition for the Google platform. Net advertising revenue, excluding TAC was up 1.2% sequentially and 14.2% year over year.

Total revenue excluding total traffic acquisition costs came in at $11.1 billion, 1.8% lower than our estimated $11.3 billion.

The U.S. generated around 45% of revenue, up 18.3% sequentially and 38.0% from a year ago. The U.K., with a 9% revenue share was down 4.8% sequentially and up 12.3% from last year. Other international markets accounted for the remaining 42% of revenue, representing sequential and year-over-year increases of 2.7% and 22.9%, respectively.

Margins

The gross margin of 57.6% shrank 27 bps sequentially and 274 bps from last year. Pricing on the Google platform and declining margins at Motorola offset the positive mix resulting from weaker Motorola sales in the previous quarter. Mix was an added negative in the year-over-year comparison. The standalone Google gross margin was 60.4% (up 2 bps sequentially) compared to standalone Motorola’s 13.0% (down 760 bps sequentially). The advertising gross margin was the combined effect of revenue growth, a 4% sequential (23% year-over-year) increase in the number of paid clicks, and a 2% sequential (6% 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. This is most likely because of the increasing contribution from the mobile and emerging markets, as well as growing distribution costs.

Other costs, associated with data center operation, amortization of intangible assets, content acquisition, credit card processing and manufacturing and inventory-related costs increased significantly as a percentage of sales, which also negatively impacted the gross margin in the last quarter.

Operating expenses of $4.92 billion were up 8.2% sequentially and 26.4% from the Jun quarter of 2012. The operating margin was 22.8%, down 259 bps sequentially and down 464 bps from last year. All expenses increased sequentially as a percentage of sales although R&D and S&M increased the most. Cost of sales and R&D registered the most significant increases from last year.

Non-operating gains were $247 million, up from $134 million in the previous quarter and down from $253 million in the Jun 2012 quarter.

Google reported net income of $2.64 billion excluding $89 million in restructuring charges. This was 18.7% of sales, compared to $3.39 billion, or 24.3% of sales in the Mar 2013 quarter and $2.83 billion, or 24.0% of sales in the year-ago quarter. GAAP earnings of $9.54 a share were down from $9.94 in the previous quarter and $8.42 in the Jun quarter of 2012.

Balance Sheet

Google has a solid balance sheet, with cash and short term investments of nearly $54.4 billion, up $4.33 billion during the quarter. The company generated around $4.71 billion from operations in the last quarter and spent $1.61 billion on capex, netting a free cash flow of $3.09 billion.

Our Take

Google has focused on building its market share on the mobile platform, as the desktop segment continues to shrink. However, its ad technology has not kept up, leading to poorer ROI for advertisers, which has impacted spending on Google platforms. Google has now introduced “AdWords Enhanced Campaigns”, which enables advertisers to run each campaign across multiple platforms (desktop/mobile), helping them make use of location-based data, generate fresh leads, increase click through rates, improve conversion and increase ROI. Google has set Jul 22 as the last date for compulsory migration to the Enhanced Campaigns platform and stated that 75% of active campaigns have already upgraded. While this will likely have a negative impact on pricing and volumes in the near term, the longer-term impact should be positive because advertisers stand to gain.

The competitive landscape has changed a lot in the last few years and the company needs to do all it can to maintain its lead in the advertising market. Its traditional competitor Yahoo (YHOO) is pulling up its socks and Microsoft (MSFT) should also not be discounted. But the most dangerous of all is likely to be Facebook (FB), which has crept up on the online advertising market. We also anticipate margin pressures as a result of the increasing competition and a growing hardware business.

At the same time, we note that Google’s initiatives in the ecommerce segment (both retail and payment platforms), its Google Fibre initiative, its Nexus and Chromebook platforms, the GDN and DoubleClick platforms, and the success of YouTube make it a power to reckon with.

Google generates revenue primarily from the sale of advertising space on its online properties. It has therefore focused on protecting and growing its position in the search market through continued innovation and quality improvements. This focus has ensured that it remains the dominant player in search across desktop and mobile platforms. Google’s Android OS has gone a long way toward cementing its position in the mobile segment. Google has also made acquisitions over time that have augmented its in-house capabilities.

To top it all, Google has shown superb execution to date that has kept the shares buoyant. As a result, its share price has appreciated 53.6% over the past year.

Google shares therefore carry a Zacks Rank #3 (Hold).

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