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Google's Q3 Highlights Changing Ad Business, Rising Costs

Google’s (GOOGL) third-quarter earnings of $4.91 missed the Zacks Consensus Estimate by 43 cents, on revenue that missed by 0.3%. Earnings did however exceed year-ago levels by 5.2% on revenue that increased 20.1%. Google shares were down 0.7% during the day but slid another 2.1% after the company reported results.

There wasn’t a whole lot of change during the quarter except what seems to be stronger pricing, improved network revenue and slowing volumes. And Google added 3,000 employees, which seems like a big number but not when you consider the 3,500 it will shed after the Motorola sale closes.

The strength in “Other” revenue remains impressive, which is an indication of the effectiveness of its diversification strategy and also the increased focus on the cloud. This is particularly significant given the growing challenges in its core search business. While management noted stronger sales on mobile, the platform necessitates a greater reliance on apps than browsers, which could mean relatively lower search traffic.

In this environment, the pressure from Microsoft (MSFT) is not letting up – in fact Microsoft seems to be getting ever closer to Apple (AAPL), which has for long kept Google as the default search option on its devices. Additionally, social networking companies like Facebook (FB) are capturing user attention for increasing periods of time and attempting new technologies like graph search and deep linking that are keeping users away from Google.

The numbers in detail-

Revenue

Gross total revenue was $16.52 billion, which was a 3.6% sequential and 20.1% year-over-year increase, driven by stronger revenue from advertising revenue on Google websites and Other revenue.

Revenue from Google-owned sites was up 2.9% sequentially, while that from partner sites was up 0.2% resulting in a total advertising revenue increase of 2.2%. Both segments continued to grow 19.8% and 9.0%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 68% and 21% of quarterly revenue, respectively.

The year-over-year increase in Google site revenue was attributed to strength on the mobile platform, while the AdMob and Ad Exchange businesses was responsible for the revenue increase at partner sites.

Other revenue was up 15.4% sequentially and 49.7% year over year to a little over 11% of revenue. Both Play Store sales (apps, content and chromecast) and higher licensing revenue drove the increase.

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 1.6% sequentially and 12.7% from the year-ago quarter (down 14 bps and 88 bps, respectively as a percentage of advertising revenue).

TAC related to AdSense arrangements has not increased much in recent quarters as revenue from partner websites has also been range-bound, but both revenue and related TAC showed a substantial year-on-year increase in the last quarter. Distribution-related TAC on the other hand, continues to increase steadily.

Net advertising revenue, excluding TAC was up 2.4% sequentially and 18.4% year over year.

Total revenue excluding total TAC came in at $13.18 billion, up 4.1% sequentially and 22.2% year over year, just short of our estimated $13.21 billion.

The U.S. generated around 42% of Google revenue, up 5.3% sequentially and 14.6% from a year ago. The U.K., with a 10% revenue share was up 0.4% sequentially and 17.1% from last year. Other international markets accounted for the balance, representing sequential and year-over-year increases of 2.7% and 26.1%, respectively.

Margins

The gross margin of 59.5% shrank 220 bps sequentially and 119 bps from last year. Pricing remained a slight negative. The increasing contribution from the mobile and emerging markets, as well as growing distribution costs were other factors.

Moreover, other costs, associated with data center operation, amortization of intangible assets, content acquisition and manufacturing and inventory-related costs increased a couple of points as a percentage of sales, which also negatively impacted the gross margin in the last quarter.

The cost per click (CPC.V) was flat sequentially and down 2% from last year. While both Google and network CPC contributed to the year-over-year decline, the 1% sequential decline in Google-owned sites was offset by a 2% increase at network sites.

Despite the CPC decline, overall paid click growth was just 2% and 17% from the two periods, respectively. Click volumes at Google sites decelerated (up 4% sequentially and 24% year over year). Network click volume growth of 2% and -4%, respectively was also disappointing.

The click volume and CPC indicate stronger pricing so Google is either changing tactics or generating synergies or a doing a bit of both.

Operating expenses of $5.73 billion were up 2.6% sequentially and 24.9% from the Sep quarter of 2013. The operating margin was 24.8%, down 186 bps sequentially and 252 bps from last year. All expenses increased year on year as a percentage of sales, but S&M increased the most, followed by R&D and then a marginal increase in G&A. S&M also increased sequentially while other expenses declined.

Non-operating gains were down again to $133 million compared to $145 million in the previous quarter but were well over the $14 million in the Sep 2013 quarter.

Google reported net income of $3.38 billion, or 20.4% of sales, compared to $3.49 billion, or 21.9% of sales in the Jun 2014 quarter and $3.16 billion, or 23.0% of sales in the year-ago quarter. GAAP earnings of $4.09 a share were down from $4.99 in the previous quarter and to from $4.38 in the Sep quarter of 2013.

Balance Sheet

Google has a solid balance sheet, with cash and short term investments of around $62.16 billion, up $953 million during the quarter. The company generated around $5.99 billion from operations in the last quarter and spent $2.42 billion on capex, netting a free cash flow of $3.58 billion. Google also spent $1.14 billion on acquisitions.

To Conclude

Google continues to work on growing its advertising revenue protecting and growing its position in the search market through continued innovation and quality improvements. Its “AdWords Enhanced Campaigns” that enables advertisers to run a campaign across multiple platforms (desktop/mobile), helping them make use of location-based data, generate fresh leads, increase click through rates, improve conversion and increase ROI is helping it penetrate the mobile segment. But this is not the only trick up its sleeve. Google also has programmatic buying tools and product listing ads that have been positive for this business.

While there has been some dissatisfaction at network partners on account of algorithm changes and Google products that increasingly compete against them, the network revenue increase in the last quarter was heartening and could be a positive indicator of things to come.

At the same time, the company remains strongly focused on diversifying its business. While it’s mobile push was initially directed at maintaining search market share, this is not the only growth avenue open today. With its latest product launches, Google has taken a two-pronged approach to the consumer side of mobile. With the Android One initiative, it is now targeting the lowest end of the market while the latest Nexus devices seek to challenge the high end.

Additionally, it is expanding the hardware partner base to remain in control. The low end will support its advertising business while the high end will make a more meaningful contribution to Play Store sales.

On the enterprise side, Google is leveraging the BYOD concept to enter the workplace with its cost-effective chromebooks. What’s more, it is supplementing these with cloud-based services that could make the customer base sticky. These efforts remain small as of now, but Google has what it takes to make a difference.

While some may consider X-Labs as a place reserved for moonshots, this is not really true. Google’s recent headcount additions point to a focus on hardware design, which will support the rest of its growth strategy.

Despite the many moving parts, Google has shown superb execution to date, which makes us optimistic about its future growth.

Google shares have a Zacks Rank #3 (Hold).

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