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Google Has a Blowout Quarter

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Google Inc reported third-quarter earnings of $11.24, blowing away the Zacks Consensus Estimate by $3.09, or 36.7%. While CPCs continued to decline, the number of clicks increased, which along with the growth at Motorola were big positives for the quarter. The tax rate was also significantly lower. As a result, shares jumped 8.18% in after-hours trading.


Google’s gross revenue came in at $14.89 billion, representing sequential and year-over-year growth of 5.6% and 5.6%, respectively. Google standalone revenue grew 14.1% sequentially and 19.3% year over year.

Revenue from Google-owned sites grew 5.9% sequentially, while partner sites dropped 1.4% resulting in net growth of 4.0%. The initiatives to increase the protection of users continued to impact growth at partner sites. Both segments continued to grow (21.6% and 0.5%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 63% and 21% of quarterly revenue, respectively.

Other revenue was up 17.6% sequentially and 84.7% year over year to a little over 8% of revenue. Management attributed the increase to higher Play Store sales (apps and content).

The Hardware and Other segment (Motorola) accounted for a little less than 8% of revenue, jumping 12.3% sequentially, but staying 56.5% below year-ago levels. Management mentioned the Moto X launch but did not say anything about its uptake.

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 1.3% sequentially and up 7.2% from the year-ago quarter (down 128 bps and 183 bps, respectively as a percentage of advertising revenue).

However, while TAC related to AdSense arrangements is declining, distribution-related TAC is on the rise. This is significant, as it is indicative of growing competition for the Google platform. Net advertising revenue, excluding TAC was up 5.8% sequentially and 18.3% year over year.

Total revenue excluding total traffic acquisition costs came in at $11.9 billion, up 7.5% sequentially and 5.2% year over year, slightly higher than our estimated $11.7 billion.

The U.S. generated around 44% of revenue, up 3.0% sequentially and 12.3% from a year ago. The U.K., with a 10% revenue share was up 5.3% sequentially and 14.3% from last year. Other international markets accounted for the remaining 46% of revenue, representing sequential and year-over-year increases of 6.8% and 28.3%, respectively.


The gross margin of 60.6% expanded 297 bps sequentially and 709 bps from last year. Pricing on the Google platform and higher costs at Motorola and negative mix were offset by higher volumes. The standalone Google gross margin was 67.7% (up 735 bps sequentially) compared to standalone Motorola’s -33.0% (down 4,604 bps sequentially).

The advertising gross margin was the combined effect of an 8% sequential (26% year-over-year) increase in the number of paid clicks, and a 4% sequential (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. This is most likely because of the increasing contribution from the mobile and emerging markets, as well as growing distribution costs. Notably, Yahoo’s search business saw slower growth in paid clicks and also a smaller decline in prices. This seems to indicate competitive pressures for Google.

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

Operating expenses of $4.61 billion were down 6.3% sequentially and 4.2% from the Sep quarter of 2012. The operating margin was 29.7%, up 689 bps sequentially and down 1,026 bps from last year. All expenses declined sequentially as a percentage of sales. This is particularly encouraging and speaks of very good cost control, since Motorola distribution costs were stepped up.

Non-operating gains were $65 million, down from $247 million in the previous quarter and slightly higher than the $63 million in the Sep 2012 quarter.

Google reported net income of $3.84 billion excluding $89 million in restructuring charges. This was 25.8% of sales, compared to $2.64 billion, or 18.7% of sales in the Jun 2013 quarter and $2.18 billion, or 15.4% of sales in the year-ago quarter. GAAP earnings of $11.30 a share were up from $9.54 in the previous quarter and $6.53 in the Sep quarter of 2012.

Balance Sheet

Google has a solid balance sheet, with cash and short term investments of around $56.5 billion, up $2.09 billion during the quarter. The company generated around $5.08 billion from operations in the last quarter and spent $2.29 billion on capex, netting a free cash flow of $2.79 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. 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 is pulling up its socks and Microsoft (MSFT - Free Report) should also not be discounted. But the most dangerous of all is likely to be Facebook (FB - Free Report) , 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 27.9% over the past year.

We expect positive estimate revisions on the back of its solid results, which should raise the current Zacks Rank of #4 (Sell).

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