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What's Dragging Down Google's Results?

Sejuti Banerjea

Google (GOOGL) missed the Zacks Consensus Estimate by 5 cents, or less than 1% on revenue that also missed by less than 1%. Earnings did, however, exceed year-ago levels by 6.0% on revenue that increased 10.4%. Despite the growth, investors punished the shares, sending Google Class A shares (GOOGL) down 3.3% and Google Class C shares (GOOG) down 3.2%.

Loss of revenue from Motorola, which was around 7% of revenue in both the previous and year-ago quarters impacted results in the last quarter. Google standalone revenue was down 1.8% sequentially but jumped 19.1% year over year.

The other sore point was the cost per click (:CPC), which was flat sequentially but down 9% year on year. This did, however, generate paid click growth of -1% and 26% from the two periods, respectively.

Compare this with Yahoo (YHOO) search, where an 8% year-on-year increase in prices allowed for a mere 6% increase in paid clicks. So Google appears to be picking up a lot of lower-priced clicks that Yahoo is leaving on the table (note that Google saw very strong double-digit growth in non-U.S, non-U.K. revenue).

The numbers in detail-

Revenue

Revenue from Google-owned sites was flat sequentially, while that from partner sites was down 3.5% resulting in net advertising revenue decline of 1.4%. Both segments continued to grow (21.2% and 4.1%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 68% and 22% of quarterly revenue, respectively.

Other revenue was down 5.8% sequentially and up 48.1% year over year to around 10% of revenue. Management attributed the increase to higher Play Store sales (apps, content and chromecast).

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 down 2.4% sequentially and up 9.3% from the year-ago quarter (down 22 bps and 154 bps, respectively as a percentage of advertising revenue).

TAC related to AdSense arrangements has been declining in recent quarters, although distribution-related TAC has been increasing steadily. The steady increase in distribution-related TAC is significant, as it is indicative of growing competition for the Google platform.

Net advertising revenue, excluding TAC was down 1.2% sequentially and up 18.9% year over year.

Total revenue excluding total TAC came in at $12.2 billion, down 10.0% sequentially and up 10.7% year over year, slightly lower than our estimated $12.3 billion.

The U.S. generated around 43% of Google revenue, down 24.1% sequentially and up 14.1% from a year ago. The U.K., with a 10% revenue share was up 5.3% sequentially and 13.9% from last year. Other international markets accounted for the balance, representing sequential and year-over-year increases of 32.1% and 25.3%, respectively.

Margins

The gross margin of 61.3% expanded 537 bps sequentially and 342 bps from last year, positively impacted by the exclusion of Motorola. Pricing remained a negative as explained above. The increasing contribution from the mobile and emerging markets, as well as growing distribution costs were other factors.

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

Operating expenses of $5.34 billion were down 2.8% sequentially and 17.5% from the Mar quarter of 2013. The operating margin was 26.7%, up 333 bps sequentially and 132 bps from last year. R&D and G&A increased sequentially as a percentage of sales while S&M fell.

Non-operating gains were $357 million, up from $125 million in the previous quarter and $134 million in the Mar 2013 quarter.

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Google reported net income of $3.65 billion, or 23.7% of sales, compared to $3.39 billion, or 20.1% of sales in the Dec 2013 quarter and $3.39 billion, or 24.3% of sales in the year-ago quarter. GAAP earnings of $5.33 a share were up from $5.03 in the March quarter of 2013.

Balance Sheet

Google has a solid balance sheet, with cash and short-term investments of around $59.4 billion, up $662 million during the quarter. The company generated around $4.39 billion from operations in the last quarter and spent $2.35 billion on capex, netting a free cash flow of $2.04 billion. Google also spent $2.95 billion on acquisitions.

To Conclude

Google introduced “AdWords Enhanced Campaigns” last year, 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. The longer-term impact of the initiative 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 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.

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, Chromebook and Chromecast 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, as a result of which, its share price has appreciated 44.0% over the past year.

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