(GOOG) Google Quarterly Earnings Report Beats Expectations Yet Again

Google Inc (GOOG) had another blow-out quarter, with reported earnings exceeding the Zacks Consensus by 65 cents, or 9.1%. This was in spite of the fact that there were a significant number of upward revisions to the Consensus over the past 3 months and even during the last 7 days. For the second straight quarter, Google’s positive surprise was well ahead of the average surprise in the preceding four quarters.

Google shares were sluggish during the day, losing 0.79%, but gained 1.31% after the company announced results.

Strong revenue, good cost control, and a slightly lower tax rate were the positives for the quarter. Promotional expenses for Google Chrome, small and mid-sized customer acquisitions, 1,000 new recruits and salary increases raised costs. Google also purchased the New York office building, which significantly lowered free cash flow.

This brought to an end a solid year, in which Google grew revenue, gross margin, operating margin, net margin, earnings and cash flow.

Revenue

Google reported gross revenue of $8.44 billion, up 15.8% sequentially and 26.5% year over year. Currency was slightly positive in the sequential comparison and slightly negative in the year-over-year comparison, after taking into account the benefits of Google’s hedging program.

Revenue growth may be attributed to a 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 display, YouTube and mobile were the growth discoveries for 2010 and each represented significant growth potential for the company.

Revenues from both Google-owned and partner sites were up double-digits on both sequential and year-over-year bases. Google websites accounted for around 67% of quarterly revenue, while partner sites accounted for another 30%. Total advertising revenue was up 16.1% sequentially and 26.3% year over year.

Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was up 14.5% sequentially and 18.4% from last year. However, traffic acquisition cost as a percentage of total advertising revenue was down 29 basis points (bps) sequentially and 122 bps from last year. Net advertising revenue, excluding traffic acquisition cost, was down 1.1% sequentially and 4.6% year over year.

Licensing and other fees brought in the remaining 3% of revenue in the last quarter, up 7.5% sequentially and 30.9% from December 2009.

Similar to eBay Inc (EBAY), Google noted improved results in Germany, but slower growth in the U.K. Non-European countries like Australia, Brazil and Japan performed well during the quarter. Overall, Google generated 48% of revenue in the U.S. (up 7.7% sequentially), the U.K. generated 10% (up 4.5%), while other countries accounted for the balance (up 30.9%).

Margins

The gross margin of 65.1% was up 12 bps sequentially and 118 bps from the year-ago quarter. The gross margin expansion was the result of solid revenues, an 11% sequential and 18% year-over-year increase in the number of paid clicks, as well as a 4% sequential and 5% 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 $2.51 billion were higher than the previous quarter’s $2.19 billion. The operating margin was 35.3%, up 37 bps from the 35.0% recorded in the previous quarter. S&M expenses increased as a percentage of sales from both the previous and year-ago quarters. This was mainly on account of higher promotional expenses for Google Chrome, acquisition costs related to small and medium sized advertisers and extra salary/bonus expenses. G&A declined as a percentage of sales from both the previous and year-ago quarters. R&D, while down sequentially, was up significantly from last year, reflecting the higher headcount and Google’s R&D focus in general.

Non-operating income of $160 million, although down slightly on a sequential basis, nearly doubled from the year-ago level.

Google reported net income of $2.54 billion, or 30.1% of sales, compared to $2.17 billion, or 29.7% of sales in the September 2010 quarter and $1.97 billion, or 29.6% of sales in the year-ago quarter. GAAP earnings of $7.81 a share jumped from $6.72 in the previous quarter and $6.13 in the December quarter of 2009. There were no special items in the last quarter.

Balance Sheet

Google has a solid balance sheet, with cash and short-term investments of $35.0 billion, up $10.5 billion during the quarter. The company generated around $3.5 billion from operations in the last quarter and spent $2.5 billion on capex, netting a free cash flow of $981 million. 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) and Microsoft Corp (MSFT), 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. During the third quarter conference call, Google announced three other important growth engines—display, YouTube and mobile. We expect all three to increase in importance over the next few years. For the first time, management provided some color on the revenue potential of each. Accordingly, it appears that display is already running at a $2.5 billion runrate and mobile at a $1 billion runrate. Additionally, YouTube is already monetizing over 2 billion views per week.

Another area that Google seems to be focusing on right now is 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.

Google also announced executive changes and we think Schmidt’s new role will include taking some of the regulatory heat off Google. We feel positive about the change. We think this is one area that has troubled the company over the past year, impacting investor confidence.

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

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