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Google Q2 Earnings: A Cloud but No Storm

googIntel kicked off the technology earnings season with positive surprises earlier this week but Thursday, the keg seemed to run dry early at the party and things turned grim.  Google and Microsoft both released earnings and neither company satisfied the appetites of a nervous market.   The initial reaction was to buckle the seat belt and grab on, the ride looked like it was about to get rough; and in fact it did.  Google’s news led to a more than 10% sell off in after-hours trading.  The bright side: Google’s news wasn’t really bad.  The selloff, or at least the rationale for it, appears to have been premature.

With more advertising dollars shifting to the Internet, Google’s top line earnings were up.  Search share was up.  Paid Click results were decent (about equal with Q1).  Revenue growth was strong.

Overall, Google reported gross revenues up 39 percent to $5.37 for the second quarter (up from $3.87b for the year ago period and up 3% sequentially over the first quarter).  All in line with expectations. 

Where things fell short was the bottom line.  Net income grew 35% to $1.25b, $3.92 a share compared to $925m ($2.93 a share) in the same period a year ago.   Profits, excluding stock options, were $4.63 a share. The Wall Street consensus expectations were for $4.74 a share.

The trouble seems to stem from a dangerous alchemy: mixing positive statements that fuel high expectations with the fact that Google famously refuses to give Wall Street analysts forward guidance on what to expect.

To start with, Google has a history of beating expectations.  Prior to this quarter, they beat the street 13 out of fifteen times.  Further fueling that, Google blew away expectations with positive results in the first quarter.   At the time CEO Eric Schmidt told analysts “[the company is] well positioned for 2008 and beyond, regardless of the business environment we are surrounded by.”   His m essage: the bad economy won’t hurt us.  Last week at an Idaho conference, he reiterated that point and emphasized Google ’s confidence saying “we make our own weather.”

Those comments set a tone; an expectation.  Going into the earnings announcement, stellar results seemed almost assured.

Further setting the stage, without corporate guidance to offset them, analysts have been working their abacuses and building models to trying to predict performance with potentially incomplete information.

High hopes plus incomplete data equals trouble.

It’s kind of the equivalent of going outside at night, seeing some clouds in the sky and then predicting: “tomorrow it will rain.”  The clouds are evidence of the possibility, it could happen, but if you made the forecast without seeing a satellite map or consulting a proper forecast, it’s not a big surprise if you end up being wrong.

As of May Google held 62 percent of the US search market, up from 58 percent at the start of the year (ComScore).  More than 90% of Google’s revenue comes from search and that market doesn’t appear to be withering in the more difficult economic climate.

To support that view, and to reassure there isn’t anything amiss, Google hauled out the big guns – former UC Berkeley economist Hal Varian.   Hal said “revenue growth, largely from sales and advertising that run alongside Google search results, is positive in every major sector, except for real estate, and even that one is only down a small amount.”

The earnings miss doesn’t appear to be an issue of core operations or a representation of the search market.   Instead, the miss seems to stem from cash management.  (Google has $12.7b in cash).  More specifically, it owes in some part to “Other Income and Expenses.”  On the quarter, the category saw a decline to $57.9m from $137.1 in the period a year ago.  Google also spent more to hedge foreign currency exposures, an apparent necessity as international revenues are become a majority (52%) of revenue.

CFO George Reyes cited cash yields and lost interests on teh cash used to buy doubleclick. Explaining things, Schmidt added more color.  He told the Financial Times, “As best we can tell,” [analysts] didn’t back out the cash we paid for DoubleClick.” With a smaller amount of money in the bank, interest income was less than they expected.

If analysts had complete guidance or were slightly more conservative, the miss might well have turned out to be a hit. Instead, forecasts for beach weather were met with the reality of a cloud or two in the sky. The good news, they should for the most part blow on by.

The Wildcard: Any future Microhoo Impact?
For now, the ongoing Microsoft Yahoo fiasco doesn’t seem to be impacting Google but, in a hypothetical situation   it could have a negative impact.  If, for instance, Icahn wins control of Yahoo’s board in his proxy fight, or if Yahoo and Microsoft otherwise tie up, and if the Yahoo and Google search pact is surprisingly blocked by regulators or otherwise quashed …and then either Microsoft or Yahoo add AOL to the mix (Google supplies search to AOL and owns 5% of the company), it could reverse some of Google’s momentum in search and trim a few points of market share.  But that’s a lot of “ifs” …enough that it’s confusing to even write out.  Anything that complicated isn’t likely.  Odds are, there’s no near-term reason to be concerned.

Back to the earnings: This was the third time since going public in 2004, the third out of sixteen reports,  that Google came up short.  Interestingly, the last time was a year ago when reporting the same period’s prior year results.  Guess Spring to Summer isn’t Google’s best season?

Google Results By the Numbers:
Revenues :
Google reported revenues of $5.37 billion for the quarter ended June 30, 2008, representing a 39% increase over second quarter 2007 revenues of $3.87 billion and a 3% increase over first quarter 2008 revenues of $5.19 billion.  Google reports its revenues, consistent with GAAP, on a gross basis without deducting TAC. 

Owned vs. Network Sites:
Google-owned sites generated revenues of $3.53 billion, or 66% of total revenues, this quarter.  This represents a 42% increase over Q2 2007 revenues of $2.49 billion and a 4% increase over Q1 2008 revenues of $3.40 billion.   
Google’s partner sites generated revenues, through AdSense programs, of $1.66 billion, or 31% of total revenues, this quarter.  That was a 22% increase over network revenues of $1.35 billion generated in the Q2 2007 and a 2% decrease over Q1  2008 revenues of $1.69 billion.  

Geographic Distributions:
•International revenue (revenue from outside of the United States) was $2.80 billion, or 52% of total revenues on the quarter. That was up slightly compared to 48% in the second quarter of 2007 and, also up sequentially, to 51% compared to the first quarter of 2008.  (If calculated constant exchange rates from the first quarter through the second quarter, revenues would have been $88 million lower. At constant exchange rates from Q2 2007 through the second quarter of 2008, current revenues would have been $249 million lower.) 
•Singling out the United Kingdom, revenue there totaled $774 million, representing 14% of revenue this quarter, compared to 15% in the Q2 2007 and 15% in the Q1 of 2008.

Paid Clicks :
Aggregate paid clicks, the number of times ads are actually clicked on (which include clicks related to ads served on Google sites and the sites of AdSense partners), increased approximately 19% over the Q2  2007 and were down approximately 1% over the Q1 of 2008.    

In Q1 the company had said they were showing fewer but better ads and attributed performance results to quality over quantity.  That seemed to be the theme for this quarter as well.

TAC – Traffic Acquisition Costs:
•Revenues shared with Google’s partners, or TAC, decreased slightly to $1.47 billion in the this quarter versus TAC of $1.49 billion in Q1 of 2008.  TAC as a percentage of advertising revenues was 28% in the second quarter, compared to 29% in the Q1 of 2008.
•TAC expense paid to our AdSense partners totaled $1.32 billion. 

Other Cost of Revenues :
Other cost of revenues, which is primarily costs related to data center operational expenses, amortization of intangible assets, credit card processing charges and content acquisition costs, increased to $674 million, or 13% of revenues versus $624 million, or 12% of revenues, in Q12008.

Operating Expenses :
Operating expenses, other than cost of revenues, were $1.64 billion, or 31% of revenues, compared to $1.53 billion in Q1 2008, or 29% of revenues. 

Operating Income:
GAAP operating income was $1.58 billion, or 29% of revenues.  This compares to GAAP operating income of $1.55 billion, or 30% of revenues, in Q1 of 2008.  Non-GAAP operating income was $1.85 billion, or 34% of revenues versus non-GAAP operating income of $1.83 billion, or 35% of revenues, in the first quarter of 2008.

Net Income:
 GAAP net income for the second quarter of 2008 was $1.25 billion as compared to $1.31 billion in the first quarter of 2008.  Non-GAAP net income was $1.47 billion in the second quarter of 2008, compared to $1.54 billion in the first quarter of 2008.  GAAP EPS for the second quarter of 2008 was $3.92 on 318 million diluted shares outstanding, compared to $4.12 for the first quarter of 2008, on 317 million diluted shares outstanding.  Non-GAAP EPS for the second quarter of 2008 was $4.63, compared to $4.84 in the first quarter of 2008. 

Cash Flow and Capital Expenditures :
•Net cash provided by operating activities totaled $1.77 billion as compared to $1.78 billion for Q1 2008.  Capital expenditures were $698 million, the majority of which was related to IT infrastructure investments, including data centers, servers, and networking equipment. 
•Free cash flow, which is an alternative measure of liquidity defined as net cash provided by operating activities less capital expenditures,  was $1.07 billion. 

More detailed press coverage on Google’s finances can be found at:
Yahoo Finance
Google Finance

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Google Q3 Earnings
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