A Rare Miss for Google (GOOG) on Second-Quarter Earnings

Posted by: Rob Hof on July 17, 2008

My quick take on Google’s second-quarter earnings (full release after the jump and updates from conference call below): It’s a miss, though not a huge one.

My full story is here, and below are notes from the conference call:

CEO Eric Schmidt says he’s “obviously very pleased with what we believe are very good results” in a normally slow quarter and in a tough economic environment.

Outgoing CFO George Reyes says paid clicks were up 19%, a sharp slowdown, which he continued to attribute to quality improvements—that is, placing fewer ads on sites with little useful content. Capital spending was at $698 million, certainly not a small number and spending that Reyes implies will continue apace.

Economist Hal Varian acknowledges weakness in a lot of sectors, but says query growth is positive in every sector, even those like autos and real estate you’d expect to be down. Revenue growth is also up from a year ago in all sectors except real estate, which he said was down only slightly. He didn’t say how much query or revenue growth was up.

Now, to some of the analysts’ questions:

Brian Pitts of BofA asks about ad coverage. Jonathan Rosenberg, senior vice-president of product management, says he sees little change in Google’s efforts to improve ad quality by showing fewer but more relevant ads on pages. But cofounder and president of products Sergey Brin says “perhaps we were a little overly aggressive in decreasing coverage in this quarter,” so that could change a bit. That certainly could help results next quarter and beyond, and may please investors always looking for scraps of visibility on Google’s outlook.

Justin Post at Merrill Lynch asks about the impact of the economy. Schmidt: “We continue to believe that we’re positioned very very well … because of a flight to quality and to performance.” Varian adds: “We have a little bit of the Wal-Mart effect: people are watching their dollars and therefore shopping more.”

He also asks about YouTube. Schmidt: “We’re enormously happy with YouTube,” but repeats that they haven’t seen the perfect ad format for YouTube.

Mark Mahaney at Citi asks about costs being up a bit more than expected. Reyes says it’s largely legal costs, which Schmidt says will be “bursty” depending on when and how many lawsuits get filed. In other words, it was relatively onetime and might explain part of the earnings miss this quarter—thanks, Viacom.

Ben Schachter of UBS asks about headcount, with an increase of 448 in the quarter down quite a bit. Schmidt says with the company at such a large size now, 19,604 people, “we don’t need massive new (numbers of) people.” That also may reassure some investors, eventually.

Jeetil Patel of Deutsche Bank asks about ad coverage. Brin basically repeats what he said before with bigger words like “asymptote.”

Questions about wireless, but I didn’t hear much new there.

And that’s it for the call.

Here’s the full release, after the jump:

MOUNTAIN VIEW, Calif. – July 17, 2008 - Google Inc. (NASDAQ: GOOG) today announced financial results for the quarter ended June 30, 2008.

"Strong international growth as well as sustained traffic increases on Google's web properties propelled us to another strong quarter, despite a more challenging economic environment," said Eric Schmidt, CEO of Google. "As we continue to focus on innovating in our core business of search, ads and apps, we also look forward to enhancing the experience of our users and expanding the reach of our advertisers and partners with new technologies and formats, particularly as our integration of DoubleClick gains momentum and creates new opportunities in display advertising and elsewhere."

Q2 Financial Summary

Google reported revenues of $5.37 billion for the quarter ended June 30, 2008, an increase of 39% compared to the second quarter of 2007 and an increase of 3% compared to the first quarter of 2008. Google reports its revenues, consistent with GAAP, on a gross basis without deducting traffic acquisition costs, or TAC. In the second quarter of 2008, TAC totaled $1.47 billion, or 28% of advertising revenues.

Google reports operating income, net income, and earnings per share
(EPS) on a GAAP and non-GAAP basis. The non-GAAP measures, as well as free cash flow, an alternative non-GAAP measure of liquidity, are described below and are reconciled to the corresponding GAAP measures in the accompanying financial tables.

• GAAP operating income for the second quarter of 2008 was $1.58
billion, or 29% of revenues. This compares to GAAP operating income of $1.55 billion, or 30% of revenues, in the first quarter of 2008.
Non-GAAP operating income in the second quarter of 2008 was $1.85 billion, or 34% of revenues. This compares to non-GAAP operating income of $1.83 billion, or 35% of revenues, in the first quarter of 2008.

• 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 in the second quarter of 2008 was $1.47 billion, 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 in the second quarter of 2008 was $4.63, compared to $4.84 in the first quarter of 2008.

• Non-GAAP operating income, non-GAAP operating margin, non-GAAP net
income, and non-GAAP EPS are computed net of stock-based compensation (SBC). In the second quarter of 2008, the charge related to SBC was
$273 million as compared to $281 million in the first quarter of 2008. Tax benefits related to SBC have also been excluded from non- GAAP net income and non-GAAP EPS. The tax benefit related to SBC was
$48 million in the second quarter of 2008 and $51 million in the first quarter of 2008. Reconciliations of non-GAAP measures to GAAP operating income, operating margin, net income, and EPS are included at the end of this release.
Q2 Financial Highlights

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.

Google Sites Revenues - Google-owned sites generated revenues of $3.53 billion, or 66% of total revenues, in the second quarter of 2008.
This represents a 42% increase over second quarter 2007 revenues of
$2.49 billion and a 4% increase over first quarter 2008 revenues of $3.40 billion.

Google Network Revenues - Google’s partner sites generated revenues, through AdSense programs, of $1.66 billion, or 31% of total revenues, in the second quarter of 2008. This represents a 22% increase over network revenues of $1.35 billion generated in the second quarter of
2007 and a 2% decrease over first quarter 2008 revenues of $1.69 billion.

International Revenues - Revenues from outside of the United States totaled $2.80 billion, representing 52% of total revenues in the second quarter of 2008, compared to 48% in the second quarter of 2007 and 51% in the first quarter of 2008. Had foreign exchange rates remained constant from the first quarter of 2008 through the second quarter of 2008, our revenues in the second quarter of 2008 would have been $88 million lower. Had foreign exchange rates remained constant from the second quarter of 2007 through the second quarter of 2008, our revenues in the second quarter of 2008 would have been $249 million lower.

Revenues from the United Kingdom totaled $774 million, representing 14% of revenue in the second quarter of 2008, compared to 15% in the second quarter of 2007 and 15% in the first quarter of 2008.

Paid Clicks – Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 19% over the second quarter of 2007 and decreased approximately 1% over the first quarter of 2008.

TAC - Traffic Acquisition Costs, the portion of revenues shared with Google’s partners, decreased to $1.47 billion in the second quarter of 2008. This compares to TAC of $1.49 billion in the first quarter of 2008. TAC as a percentage of advertising revenues was 28% in the second quarter, compared to 29% in the first quarter of 2008.

The majority of TAC expense is related to amounts ultimately paid to our AdSense partners, which totaled $1.32 billion in the second quarter of 2008. TAC is also related to amounts ultimately paid to certain distribution partners and others who direct traffic to our website, which totaled $154 million in the second quarter of 2008.
Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, amortization of intangible assets, credit card processing charges as well as content acquisition costs, increased to $674 million, or 13% of revenues, in the second quarter of 2008, compared to $624 million, or 12% of revenues, in the first quarter of 2008.
Operating Expenses - Operating expenses, other than cost of revenues, were $1.65 billion in the second quarter of 2008, or 31% of revenues, compared to $1.53 billion in the first quarter of 2008, or 29% of revenues. The operating expenses in the second quarter of 2008 included $810 million in payroll-related and facilities expenses, compared to $809 million in the first quarter of 2008.

Stock-Based Compensation (SBC) – In the second quarter of 2008, the total charge related to SBC was $273 million as compared to $281 million in the first quarter of 2008.

We currently estimate stock-based compensation charges for grants to employees prior to July 1, 2008 to be approximately $1.1 billion for 2008. This does not include expenses to be recognized related to employee stock awards that are granted after July 1, 2008 or non- employee stock awards that have been or may be granted. We currently anticipate that dilution related to all equity grants to employees will be at or below 2% this year.

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

Interest Income and Other, Net – Interest income and other was $58 million in the second quarter of 2008, compared with $167 million in the first quarter of 2008. The decrease was primarily related to lower yields on our cash balances, as well as lower average cash balances as a result of cash used in the first quarter to acquire DoubleClick; lower net realized gains on the sale of our marketable securities; and an increase in expenses as a result of more activity under our foreign exchange risk management program.

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.

Income Taxes – Our effective tax rate was 24% for the second quarter of 2008.

Cash Flow and Capital Expenditures – Net cash provided by operating activities for the second quarter of 2008 totaled $1.77 billion as compared to $1.78 billion for the first quarter of 2008. In the second quarter of 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, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. In the second quarter of 2008, free cash flow was $1.07 billion.

We expect to continue to make significant capital expenditures.

A reconciliation of free cash flow to net cash provided by operating activities, the GAAP measure of liquidity, is included at the end of this release.

Cash – As of June 30, 2008, cash, cash equivalents, and marketable securities were $12.7 billion.

On a worldwide basis, Google employed 19,604 full-time employees as of June 30, 2008, up from 19,156 full-time employees as of March 31, 2008.

WEBCAST AND CONFERENCE CALL INFORMATION

A live audio webcast of Google’s second quarter 2008 earnings release call will be available at http://investor.google.com/webcast.html.
The call begins today at 1:30 PM (PT) / 4:30 PM (ET). This press release, the financial tables, as well as other supplemental information including the reconciliations of certain non-GAAP measures to their nearest comparable GAAP measures, are also available at that site. A replay of the call will be available beginning at 7:30 PM
(ET) today through midnight Thursday, July 24, 2008 by calling
888-203-1112 in the United States or 719-457-0820 for calls from outside the United States. The required confirmation code for the replay is 2445002.

FORWARD LOOKING STATEMENTS

This press release contains forward-looking statements that involve risks and uncertainties. These statements include statements relating to our success in integrating DoubleClick, our ability to innovate in our core business, enhance the experience of our users and expand the reach of our advertisers and partners with new technologies and formats, our expected stock-based compensation charges, the expected dilution related to equity grants to our employees, and our plans to make significant capital expenditures. Actual results may differ materially from the results predicted and reported results should not be considered as an indication of future performance. The potential risks and uncertainties that could cause actual results to differ from the results predicted include, among others, difficulties in integrating DoubleClick into our business, unforeseen changes in our hiring patterns, the amount of stock-based compensation we issue to our service providers, our need to expend capital to accommodate the growth of the business, as well as those risks and uncertainties included under the captions “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, which is on file with the SEC and is available on our investor relations website at investor.google.com and on the SEC website at www.sec.gov. Additional information will also be set forth in our report on Form 10-Q for the quarter ended June 30, 2008, which will be filed with the SEC in August 2008. All information provided in this release and in the attachments is as of July 17, 2008, and should not be unduly relied on because Google undertakes no duty to update this information.

ABOUT NON-GAAP FINANCIAL MEASURES

To supplement our consolidated financial statements, which statements are prepared and presented in accordance with GAAP, we use the following non-GAAP financial measures: non-GAAP operating income, non- GAAP operating margin, non-GAAP net income, non-GAAP EPS and free cash flow. The presentation of this financial information is not intended to be considered in isolation or as a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. For more information on these non-GAAP financial measures, please see the tables captioned “Reconciliations of non-GAAP results of operations measures to the nearest comparable GAAP measures” and “Reconciliation from net cash provided by operating activities to free cash flow” included at the end of this release.

We use these non-GAAP financial measures for financial and operational decision making and as a means to evaluate period-to-period comparisons. Our management believes that these non-GAAP financial measures provide meaningful supplemental information regarding our performance and liquidity by excluding certain expenses and expenditures that may not be indicative of our “recurring core business operating results,” meaning our operating performance excluding not only non-cash charges, such as stock-based compensation, but also discrete cash charges that are infrequent in nature. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance and when planning, forecasting and analyzing future periods. These non- GAAP financial measures also facilitate management’s internal comparisons to our historical performance and liquidity as well as comparisons to our competitors’ operating results. We believe these non-GAAP financial measures are useful to investors both because (1) they allow for greater transparency with respect to key metrics used by management in its financial and operational decision making and (2) they are used by our institutional investors and the analyst community to help them analyze the health of our business.

Non-GAAP operating income and operating margin. We define non-GAAP operating income as operating income plus stock-based compensation.
Non-GAAP operating margin is defined as non-GAAP operating income divided by revenues. Google considers these non-GAAP financial measures to be useful metrics for management and investors because they exclude the effect of stock-based compensation so that Google’s management and investors can compare Google’s recurring core business operating results over multiple periods. Because of varying available valuation methodologies, subjective assumptions and the variety of award types that companies can use under FAS 123R, Google’s management believes that providing a non-GAAP financial measure that excludes stock-based compensation allows investors to make meaningful comparisons between Google’s recurring core business operating results and those of other companies, as well as providing Google's management with an important tool for financial and operational decision making and for evaluating Google’s own recurring core business operating results over different periods of time. There are a number of limitations related to the use of non-GAAP operating income versus operating income calculated in accordance with GAAP. First, non-GAAP operating income excludes some costs, namely, stock-based compensation, that are recurring. Stock-based compensation has been and will continue to be for the foreseeable future a significant recurring expense in Google’s business. Second, stock-based compensation is an important part of our employees’ compensation and impacts their performance. Third, the components of the costs that we exclude in our calculation of non-GAAP operating income may differ from the components that our peer companies exclude when they report their results of operations. Management compensates for these limitations by providing specific information regarding the GAAP amounts excluded from non-GAAP operating income and evaluating non- GAAP operating income together with operating income calculated in accordance with GAAP.

Non-GAAP net income and EPS. We define non-GAAP net income as net income plus stock-based compensation, less the related tax effects.
We define non-GAAP EPS as non-GAAP net income divided by the weighted average shares, on a fully-diluted basis, outstanding as of June 30, 2008. We consider these non-GAAP financial measures to be a useful metric for management and investors for the same reasons that Google uses non-GAAP operating income and non-GAAP operating margin.
However, in order to provide a complete picture of our recurring core business operating results, we exclude from non-GAAP net income and non-GAAP EPS the tax effects associated with stock-based compensation. Without excluding these tax effects, investors would only see the gross effect that excluding these expenses had on our operating results. The same limitations described above regarding Google’s use of non-GAAP operating income and non-GAAP operating margin apply to our use of non-GAAP net income and non-GAAP EPS.
Management compensates for these limitations by providing specific information regarding the GAAP amounts excluded from non-GAAP net income and non-GAAP EPS and evaluating non-GAAP net income and non- GAAP EPS together with net income and EPS calculated in accordance with GAAP.

Free cash flow. We define free cash flow as net cash provided by operating activities minus capital expenditures. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the acquisition of property and equipment, including information technology infrastructure and land and buildings, can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening the balance sheet. Analysis of free cash flow also facilitates management’s comparisons of our operating results to competitors’ operating results. A limitation of using free cash flow versus the GAAP measure of net cash provided by operating activities as a means for evaluating Google is that free cash flow does not represent the total increase or decrease in the cash balance from operations for the period since it excludes cash used for capital expenditures during the period. Our management compensates for this limitation by providing information about our capital expenditures on the face of the cash flow statement and under Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-Q and Annual Report on Form 10-K. Google has computed free cash flow using the same consistent method from quarter to quarter and year to year.

Reader Comments

Bob Sanders

July 17, 2008 6:41 PM

This is a great article!

anon

July 17, 2008 9:31 PM

What does "more challenging economic environment" mean? Are Google's domestic revenues falling?

Rob Hof

July 17, 2008 9:39 PM

anon: My understanding of Schmidt's statement was that the economy at large faces big challenges. In this case, he was not apparently referring to Google revenues. But you have to think at some point, Google could get affected. It just isn't entirely obvious yet, though as Om Malik notes--http://gigaom.com/2008/07/17/why-silicon-valley-should-be-worried/-- Google's traffic acquisition costs have declined, which helps net revenues, and TAC is a bit of a black box.

AdsenseTrick.com

July 17, 2008 10:34 PM

I think Rob is correct.

It was not Google itself, but the entire environment (mean economy), because - who spend the ads ?

Thanks for this enlightening article !

Arturo Ferrando

December 8, 2011 5:45 AM

Couldn't have said it better myself.

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Bloomberg Businessweek writers Peter Burrows, Cliff Edwards, Olga Kharif, Aaron Ricadela, and Douglas MacMillan, dig behind the headlines to analyze what’s really happening throughout the world of technology. Tech Beat covers everything from tech bellwethers like Apple, Google, and Intel and emerging new leaders such as Facebook to new technologies, trends, and controversies.

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