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Google Inc reported solid first-quarter earnings of $10.07, exceeding the Zacks Consensus Estimate by $1.24, or 14.0%. Shares had dropped 2.1% during the day, but gained back 1.4% after the company announced results.
Google’s gross revenue came in at $13.97 billion, representing sequential and year-over-year growth of -3.1% and 31.2%, respectively. Excluding the $1.1 billion contribution from Motorola, revenue was up 21.7% from the year-ago quarter. The Mar quarter is typically a slow one for Google, since it follows the seasonally stronger Dec quarter.
As a result, revenue from both Google-owned and partner sites softened sequentially. While Google sites were flat, partner sites declined 5.1%, resulting in a total ad revenue decline of 1.4%. Both segments continued to grow very strongly (18.2% and 12.1%, respectively) from the year-ago quarter, the 14th straight quarter of double-digit year-over-year growth. Overall, Google-owned and partner sites brought in 62% and 23% of quarterly revenue, respectively.
Other revenue grew 26.5% sequentially and 146.8% year over year to around 8% of revenue. Management attributed the increase to higher Play Store sales (including hardware and ecommerce) but admitted that the very strong year-over-year growth was partially attributable to a 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 a little over 7% of revenue, down 32.8% sequentially. Management expects the business to remain lumpy in the near term, although the last quarter likely included some seasonality.
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 3.9% sequentially and up 18.0% from the year-ago quarter. 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 flat sequentially and up 15.9% year over year.
Total revenue excluding total traffic acquisition costs came in at $11.0 billion, 12.7% lower than our estimated $12.6 billion.
The U.S. generated around 45% of Google standalone revenue, down 2.6% sequentially and up 19.7% from a year ago. The U.K., with an 11% revenue share was up 6.3% sequentially and 20.6% from last year. Other international markets accounted for the remaining 44% of revenue, representing sequential and year-over-year increases of 0.4% and 21.7%, respectively. Motorola derives more than half its revenue from the U.S. and has a limited presence in the U.K.
The gross margin of 57.9% expanded 101 bps sequentially, while declining 648 bps from last year. The lower-margin Motorola and other hardware revenue played a major role, since Motorola didn’t contribute to the year-ago quarter and declined sequentially, positively impacting the mix of business in both comparisons.
The standalone Google gross margin was 60.3% (down 120 bps sequentially) compared to standalone Motorola’s 20.6% (up 319 bps sequentially). The advertising gross margin was the combined effect of revenue growth, a 3% sequential (20% year-over-year) increase in the number of paid clicks, and a 4% sequential (4% 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 $4.55 billion were down 5.5% sequentially and up 31.2% from the Mar quarter of 2012. The operating margin was 25.4%, up 182 bps sequentially and down 647 bps from last year. All except G&A costs declined sequentially as a percentage of sales although cost of sales also increased from the year-ago quarter.
Non-operating gains were $134 million, down from $152 million in the previous quarter and $156 million in the Mar 2012 quarter.
Google reported net income of $3.39 billion excluding $66 million in restructuring charges, or 24.3% of sales, compared to $2.91billion, or 20.2% of sales in the Dec 2012 quarter and $2.89 billion, or 27.1% of sales in the year-ago quarter. GAAP earnings of $9.94 a share were up from $8.62 in the previous quarter and $8.75 in the Mar quarter of 2012.
Google has a solid balance sheet, with cash and short term investments of nearly $50.10 billion, up $2.01 billion during the quarter. The company generated around $3.69 billion from operations in the last quarter and spent $607 million on capex, netting a free cash flow of $3.09 billion.
Google’s results are indicative of continued growth coming at lower prices. 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 - Analyst Report) is pulling up its socks and Microsoft (MSFT - Analyst Report) should also not be discounted. But the most dangerous of all is likely to be Facebook (FB - Analyst Report), which has crept up on the online advertising market.
Facebook’s Home has the potential to be a game-changer and Google+ just hasn’t gained enough momentum to counter this move in kind. We are still waiting for Google to come up with something, but we are incrementally cautious given the changing competitive environment. 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 have kept the shares buoyant. As a result, its share price has appreciated more than 27.8% over the past year.
Google shares therefore carry a Zacks Rank #2 (Buy).