(GOOG) Google Remains Search King

In typical style, Google Inc’s (GOOG) third-quarter earnings of $8.33 breezed past the Zacks Consensus Estimate of $7.59. Solid revenue growth across most geographies (other than Western Europe) and impressive growth in mobile drove results in the last quarter. Shares were up 6.37% in after-hours trading.

Historically, Google has done very much better than Yahoo Inc. (YHOO), which could be up for sale and Microsoft Corp. (MSFT), which has yet to gain critical mass. Google’s superior algorithms have consistently attracted more users and generated better conversions.

Revenue

Google’s gross revenue touched a record $9.72 billion, representing sequential and year-over-year increases of 7.7% and 33.4%, respectively. Currency impact was again positive across the world, after taking into account the benefits of Google’s hedging program.

Google is very strongly positioned in the mobile platform, where both smartphones and tablets have been making strong headway. The dominant position has enabled Google to generate mobile revenue at a $2.5 billion runrate over the past 12 months. In fact, the company’s position in mobile looks better than it was in traditional computing, which says something about its strategic planning and execution.

Additionally, Google continues to benefit from 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.

Revenues from both Google-owned and partner sites continued to grow double-digits on a year-over-year basis (they have grown double-digits each quarter over the last five years or so). Google websites accounted for around 69% of quarterly advertising revenue, while partner sites accounted for another 27%. Total advertising revenue was up 7.1% sequentially and 32.8% year over year. Google-owned sites were again stronger than partner sites.

Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was up 5.0% sequentially and 22.4% from last year. However, traffic acquisition cost as a percentage of total advertising revenue was down 48 basis points (bps) sequentially and 199 bps from last year. Net advertising revenue, excluding traffic acquisition cost was up 7.8% sequentially and 36.3% year over year.

Licensing and other fees brought in the remaining 4% of revenue in the last quarter, up 24.2% sequentially and 51.6% from September 2010.

Total revenue excluding total traffic acquisition costs came in at $7.51 billion, exceeding the Consensus Estimate of $7.2 billion by 4.2%.

The U.S. generated around 54% of revenue, growing 27.5% sequentially and 40.6% from a year ago. The U.K., with an 11% revenue share was up 7.6% sequentially and 25.0% from last year. Other markets accounted for the remaining 35% of revenue, representing a sequential decline of 13.5% and year-over-year increase of 25.9%.

The sequential decline was largely related to weakness in some Western European markets. Google stated that Australia, India and Brazil were notably strong in the last quarter and the position in Japan continued to improve.

Margins

The gross margin of 65.2% was up 39 bps sequentially and 27 bps from the year-ago quarter. The gross margin performance was the combined effect of solid revenues, a 13% sequential (28% year-over-year) increase in the number of paid clicks, and a 5% sequential decline (5% year-over-year increase) 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. Google stated that the mobile and emerging markets businesses were growing strongly, which could be the reason.

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

Operating expenses of $3.28 billion were higher than the previous quarter’s $2.97 billion. The operating margin was 31.5%, down 46 bps from the 31.9% recorded in the previous quarter and 350 bps from last year. R&D and S&M expenses increased as a [percentage of sales from both the previous and year-ago quarters, while cost of sales and G&A declined as a percentage of sales.

Google has added a large number of people in recent quarters (nearly 2,600 in the last quarter itself). Other than fresh recruits, the company typically adds quite a few through acquisitions (it added Motorola Mobility [MMI] in the last quarter).

Non-operating income of $302 million increased from $204 million in the June quarter and $167 million from last year.

Google reported net income of $2.73 billion, or 28.1% of sales, compared to $2.51 billion, or 27.8% of sales in the June 2011 quarter and $2.17 billion, or 29.7% of sales in the year-ago quarter. GAAP earnings of $8.33 a share jumped from $7.68 in the previous quarter and $6.72 in the September 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 $42.6 billion, up $3.4 billion during the quarter. The company generated around $3.95 billion from operations in the last quarter and spent $680 million on capex, netting a free cash flow of $3.27 billion. Google’s total debt was reduced by $1.93 billion during the last quarter.

Our Take

Google generates revenue primarily from the sale of advertising space on its online properties. The company is therefore focused on protecting and growing its position in the search market through continued innovation and quality improvements. This focus has ensured that the company remains the dominant player search, not just in the traditional computing segment, but even more so in the emerging mobile space.

Google’s Android OS has gone a long way to cementing its position in mobile. Google has also made acquisitions over time that have augmented its in-house capabilities.

With the growing importance of social networking, Google introduced Google Plus. The social platform appears to be gathering momentum, as management reported 40 million users (up from 10 million at reported last quarter).

Management stated that 100 new features were added to Google Plus during the quarter, which was having a positive impact on engagement. 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 and remains to be proved. In the meantime, it is obvious that social data will be an additional tool for Google, which has been making a number of acquisitions and innovations in the space. Management stated that social relevance in search was already resulting in better conversions, although data is naturally limited given the stage of the business. We feel 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 has played a key role in elevating Google’s position in display and we expect the company to take away some share from Yahoo, which is facing a number of problems. Google’s success in display is very encouraging, 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 and China. 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) and Sohu.com (SOHU) remain in government favor.

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

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