(GOOG) Google Grows But Misses Expectations in Third Quarter

Google Inc (GOOG) reported earnings of $7.35, missing our estimates by $1.53, or 17.2%.

Google’s superior algorithms have consistently attracted more users and generated better conversions.  However, the cost per click is on the rise, which is impacting both revenue and margins. The significantly lower-margin Motorola business is making matters worse.

Revenue

Google’s gross revenue touched a record $14.10 billion, representing sequential and year-over-year increases of 28.6% and 45.1%, respectively.

Google is very strongly positioned in the mobile segment, where both smartphones and tablets have been making strong headway. The dominant position has enabled Google to generate very strong mobile revenue growth. 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.

Advertising 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 few years). Google websites accounted for around 55% of quarterly revenue, while partner sites accounted for another 22%. Total advertising revenue was up 3.2% sequentially and 16.3% year over year. Partner sites did better than Google-owned sites for the first time.

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 up 6.5% sequentially and 25.2% from last year. However, we do not consider this a reason for concern yet since TAC is a necessary expense.

Moreover, TAC as a percentage of sales was 25.5% (up 80 bp sequentially and 180 bp year over year), still at manageable levels. We will be watching this figure however, since the year-over-year increase in TAC costs have been at strong double-digit rates over the last few quarters. TAC for distribution arrangements is increasing at a far higher rate than TAC for AdSense, which we fear could gain momentum given the changing competitive landscape. Net advertising revenue, excluding TAC was up 2.1% sequentially and 13.6% year over year.

The Hardware and Other segment (formed in the June quarter and comprising mainly of Motorola, but also Nexus 7) accounted for 16% of revenue in the last quarter, with 69% coming from mobile products and the balance from home products. Segment revenue was up 106% sequentially.

Licensing and other fees brought in 5% of revenue in the last quarter, up 51.7% sequentially and 73.0% from the September 2011 quarter.

Total revenue excluding total traffic acquisition costs came in at $11.34 billion, 4.4% lower than the Consensus Estimate of $11.86 billion.

The U.S. generated around 57% of revenue, up 27.8% sequentially and 50.8% from a year ago. The U.K., with a 9% revenue share was up 2.5% sequentially and 15.8% from last year. Other markets accounted for the remaining 35% of revenue, representing sequential and year-over-year increases of 2.5% and 45.2%, respectively.

Google stated that in terms of advertising revenue, the U.S., U.K. and Japan remained strong in the last quarter, while continental Europe (especially travel and retail sectors) was slow. Motorola derives more than half its revenue from the U.S. and has a limited presence in the U.K. Therefore, both the U.S. and other international markets gained from the addition of Motorola’s results in the last quarter.

Margins

The gross margin of 56.0% was flattish sequentially but down significantly from the year-ago quarter, which did not include the lower-margin Motorola hardware business. The standalone Google gross margin was 61.5% compared to standalone Motorola’s 17.9%. The advertising gross margin was the combined effect of revenue growth, a 6% sequential (33% year-over-year) increase in the number of paid clicks, and a 3% sequential (15% 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. The mobile and emerging markets businesses are growing strongly and distribution costs are increasing, which could be the reasons.

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

Operating expenses of $4.81 billion were higher than the previous quarter’s $3.91 billion. The operating margin was 21.9%, again impacted by the high hardware-related costs. R&D was down as a percentage of sales from both the previous and year-ago quarters, with S&M and G&A down sequentially, but up year over year.

Non-operating gains were $63 million, up from $254 million in the previous quarter and $302 million in the September 2011 quarter.

Google reported net income of $2.45 billion, or 17.4% of sales, compared to $1.76 billion, or 16.0% of sales in the June 2012 quarter and $2.73 billion, or 28.1% of sales in the year-ago quarter. GAAP earnings of $6.53 a share were up from $4.91 in the previous quarter and $8.33 in the September quarter of 2011. Excluding $349 million (82 cents a share on a tax-adjusted basis) for severance and benefit arrangements related to the Motorola acquisition, the pro forma EPS was $7.35 a share.

Balance Sheet

Google has a solid balance sheet, with cash and short term investments of $44.63 billion, up $1.50 billion during the quarter. The company generated around $4.00 billion from operations in the last quarter and spent $872 million on capex, netting a free cash flow of $3.13 billion.

Our Take

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, 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.

However, in the process of protecting mobile search share, Google has started a war with Apple (AAPL), as its Android-based phones have emerged as the iPhone’s prime competitors. This is gradually converting a close partner to a bitter competitor. Therefore, if Microsoft’s (MSFT) Bing starts generating comparable results and satisfaction, Apple could go with Bing rather than develop its own search algorithms.

This would cost Google billions in search revenue. Google’s innovation in search continues, but the company is also trying to use Motorola’s patents and design expertise to develop competing hardware that could hopefully soften the impact.

With the growing importance of social networking, Google introduced Google Plus. 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 has stated that social relevance in search is resulting in better conversions and the company’s success in the display format is well borne out by the latest eMarketer estimates.

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 continue chipping away at Yahoo’s market share. 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. While Facebook is expected to maintain a slight edge this year, Google is expected to become the display market leader next year.

Despite the initiatives to drive growth and superb execution to date, investors were initially shocked by Google’s miss, sending share prices down over 8%. But the actual impact is probably sinking in (shares have started climbing in the pre-market today).

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

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