Google Inc’s(GOOG - Free Report) second-quarter earnings of $7.68 thrashed the Zacks Consensus Estimate of $6.79, even as solid revenues and a lower tax rate offset declining margins. Google performed solidly across segments and geographies, allaying fears that its search business was under pressure.
Historically, Google has done very much better than Yahoo Inc and Microsoft Corp (MSFT - Free Report) , since its algorithms and conversions have been much more effective. Although the company’s search quality initiatives are having a slightly negative impact on revenues from partner sites, overall results were nothing short of exemplary.
Google’s gross revenue touched $9.02 billion for the first time, representing sequential and year-over-year increases of 5.3% and 32.3%, respectively. Currency impact was again positive across the world, 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 4.9% sequentially and 32.8% year over year. Revenue grew across both Google-owned and partner sites, although Google sites were stronger given that partner sites continued to be impacted by search quality improvements.
Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was up 3.3% sequentially and 21.7% from last year. However, traffic acquisition cost as a percentage of total advertising revenue was down 37 basis points (bps) sequentially and 221 bps from last year. Net advertising revenue, excluding traffic acquisition cost was up 5.5% sequentially and 36.8% year over year. Total revenue excluding total traffic acquisition costs came in at $6.92 billion, exceeding the Zacks Consensus Estimate of $6.6 billion by 4.7%.
Licensing and other fees brought in the remaining 3% of revenue in the last quarter, up 15.2% sequentially and 20.2% from June 2010.
The U.S. generated around 46% of revenue, growing 3.8% sequentially and 17.7% from a year ago. The U.K., with an 11% revenue share was flattish sequentially but up 26.8% from last year. Google stated that the disaster in Japan negatively impacted results in the last quarter, although the rate of recovery was much faster than expected. Other markets overall grew strongly, on both sequential and year-over-year bases despite the disaster in Japan.
The gross margin of 64.9% was down 90 bps sequentially, although up 103 bps from the year-ago quarter. The gross margin performance was the combined effect of solid revenues, a 2% sequential decline (18% year-over-year increase) in the number of paid clicks, and a 6% sequential (12% 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 $2.97 billion were higher than the previous quarter’s $2.84 billion. The operating margin was 31.9%, down 69 bps from the 32.6% recorded in the previous quarter. R&D, S&M and G&A expenses increased as a percentage of sales the year-ago quarter, although the increase in selling costs was the most significant. R&D actually declined on a sequential basis, with other operating costs increasing only slightly as a percentage of sales. Google has added a large number of people in recent quarters, announced a 10% wage hike and also acquired around 450 people through the ITA acquisition, which are the reasons for expenses increasing yet again in the last quarter. Comps should get easier next year.
Non-operating income of $204 million, declined again on a sequential basis, was up very strongly from both the previous and year-ago quarters.
Google reported net income of $2.51 billion, or 27.8% of sales, compared to $2.30 billion, or 26.8% of sales in the March 2011 quarter and $1.84 billion, or 27.0% of sales in the year-ago quarter. GAAP earnings of $7.68 a share jumped from $7.04 in the previous quarter and $5.71 in the June quarter of 2010. There were no special items in the last quarter.
Google has a solid balance sheet, with cash and short term investments of nearly $39.1 billion, up $2.4 billion during the quarter. The company generated around $3.5 billion from operations in the last quarter and spent $917 million on capex, netting a free cash flow of $2.60 billion. Google ended the quarter with a net debt increase of $2.98 billion.
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, 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. Google seems to be on track here, since it recently surpassed Yahoo as the leader in display advertising.
To these efforts, Google has now added Google Plus, its umpteenth attempt to build a successful social network. Google did provide some numbers tracking its progress – around 10 million people have joined the network, with over 1 billion items shared and received a day. The +1 button that serves as a recommendation directly from other users is currently being served around 2.3 billion times a day. All this is very good news, since Google needs its success in social networking as a valuable data collection tool. While some have commented that Google will not be as popular as Facebook, this is really not that much of a concern, since social data will be an additional tool for Google, which has been making a number of acquisitions and innovations in the space. Google might have entered the race late, but it could still have the last laugh. We feel generally optimistic about Google’s current efforts in social.
Toward the end of last year, Google stepped up efforts targeting the small and medium business (SMB) segment. The SMB segment would help diversify the revenue source, since Google is already well-entrenched at several big spenders. Additionally, the SMB segment has played a key role in elevating Google to the number one position in display and we expect the company to take away some share from Yahoo, which is currently more in favor with big spenders in display. This is another positive trend, since display advertising is expected to grow very strongly over the next few years, surpassing search advertising by 2015.
Despite the initiatives to drive growth and superb execution to date that have enabled the company to maintain share in a fast-growing market, Google shares have been range-bound, as investors remain concerned about legal matters, China and more recently, the management reorganization. China in particular has been a sore point, since the country’s Internet usage has been growing exponentially and local players such as Baidu (BIDU - Free Report) and Sohu.com (SOHU - Free Report) remain in government favor.
Google shares carry a Zacks Rank of #4, implying a short-term Sell recommendation, while Baidu is ranked #1 (Strong Buy) and Sohu #2 (Buy).