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Contrary to our expectations, Google Inc’s first-quarter earnings missed the Zacks Consensus Estimate, as its revenue increase was not enough to offset the increase in operating expenses. We estimated lower opex, not anticipating the significant headcount increase during the quarter.

Google’s earnings came in at $7.04 a share, well below the $7.14 Zacks Consensus Estimate. Shares traded up slightly during the day, but plunged in after-hours trading.

Revenue

Google reported gross revenue of $8.58 billion that was up 1.6% sequentially and 26.6% year over year, regardless of the fact that the fourth quarter was extremely strong and the first quarter of last year included Nexus One, making for slightly tougher comps on both counts. Currency was neutral in both the sequential and year-over-year comparisons, after taking into account the benefits of Google’s hedging program.

Revenue growth was attributable to 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. Google also stated that investments in display mobile and enterprise were paying off.

Revenues from both Google-owned and partner sites were up double-digits year-over-year. Google websites accounted for around 69% of quarterly revenue, while partner sites accounted for another 28%. Total advertising revenue was up 1.7% sequentially and 28.3% year over year.

However, while Google sites also grew on a sequential basis helped by strength across geographies and verticals, partner sites declined slightly due to the loss of a search distributorship partner and some search quality improvements made during the quarter.

Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was down 1.7% sequentially and up 18.8% from last year. However, traffic acquisition cost as a percentage of total advertising revenue was down 86 basis points (bps) sequentially and 196 bps from last year.

Net advertising revenue, excluding traffic acquisition cost was up 2.9% sequentially and 31.7% year over year. Total revenue excluding total traffic acquisition costs came in at $6.54 billion, exceeding the Zacks Consensus of $6.3 billion by 3.9%.

Licensing and other fees brought in the remaining 3% of revenue in the last quarter, down 1.5% sequentially and 10.3% from March 2010.

The U.S. generated around 47% of revenue, but growth slipped on a sequential basis, although it was up strong double-digits from last year. The U.K., with an 11% revenue share, continued to grow in line with the economic recovery in that country.

Google stated that the disaster in Japan negatively impacted results in the first quarter and would continue to do so in the second, but that the market remained a strong and important one for Google. Other markets overall grew on both sequential and year-over-year bases despite the disaster in Japan.

Margins

The gross margin of 65.8% was up 67 bps sequentially and 195 bps from the year-ago quarter. The gross margin expansion was the combined effect of solid revenues, a 4% sequential (18% year-over-year increase) in the number of paid clicks, and a 1% sequential decline (8% year-over-year increase) in the cost per click.

Other costs, associated with data center operation, amortization of intangible assets, content acquisition and credit card processing increased from the year-ago quarter, partially offsetting the increases in paid clicks and the cost per click.

Operating expenses of $2.84 billion were higher than the previous quarter’s $2.51 billion. The operating margin was 32.6%, down 273 bps from the 35.3% recorded in the previous quarter. R&D, S&M and G&A expenses increased as a percentage of sales from both the previous and year-ago quarters.

Higher R&D and S&M were the primary drivers of the lower margin, increasing 184 bps and 128 bps, respectively from the December quarter and 222 bps and 301 bps, respectively from the March quarter of last year. In addition to the 10% wage hike announced last quarter, Google added 1,900 people, which was the main reason for the negative surprise.

Non-operating income of $96 million, declined again on a sequential basis, but was still up significantly from the year-ago level.

Google reported net income of $2.30 billion, or 26.8% of sales, compared to $2.54 billion, or 30.1% of sales in the December 2010 quarter and $1.96 billion, or 28.9% of sales in the year-ago quarter. GAAP earnings of $7.04 a share dropped from $7.81 in the previous quarter and $6.06 in the March 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 $36.7 billion, up $1.7 billion during the quarter. The company generated around $3.2 billion from operations in the last quarter and spent $890 million on capex, netting a free cash flow of $2.28 billion. Google has no debt.

Our Take

Google generates revenue primarily from the sale of advertising space on its online properties. The company is therefore, focused on user experience and convenience, which could bring back customers and generate new ones.

It is already proved that the Google search engine generates more useful results than those from competitors Yahoo Inc (YHOO - Analyst Report) and Microsoft Corp (MSFT - Analyst Report), since it remains the most popular search engine in the world. Google has also made acquisitions over time that have augmented its in-house capabilities.

However, core search is not the only area of management focus. Last year, Google announced three other important growth engines -- display, YouTube and mobile. We expect all three to increase in importance over the next few years. In the September quarter management provided information regarding these businesses for the first time.

At that time, management stated that display was running at a $2.5 billion runrate and mobile at a $1 billion runrate. Additionally, YouTube was monetizing over 2 billion views per week.

Over the next two quarters, management maintained that these businesses, especially mobile and display were doing better than expected. This quarter, management added that mobile was starting to do better internationally.

Google also made some organization changes that increase focus on its diversification strategy. While the company is obviously focused on strengthening the core search business, it has doubled its efforts on new products and new growth avenues, stepping up innovation in the social realm.

Google recently stepped up efforts targeting the small and medium business (SMB) segment. This is undoubtedly a solid strategy, since Google is already well-entrenched at many large advertisers and additional growth opportunities will be competitive. The SMB segment would help diversify the revenue source.

Despite the initiatives to drive growth, Google shares have been range-bound, as investors remain concerned about legal matters, China and more recently, the management reorganization. However, we believe that the company has shown superb execution to date and continues to grow strongly, more or less maintaining share in a fast-growing market.

Although shares slid on the earnings miss, we want to point out that this was not the result of inefficient management, but investment in growth, which should build value for shareholders.

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

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