Google's Q2 Earnings Show Solid Execution in Search, Other

Google's (GOOGL) second quarter earnings missed the Zacks Consensus Estimate by 8 cents, on revenue that beat by 2.5%. Earnings did, however, exceed year-ago levels by 20.3% on revenue that increased 21.7%. Google shares were down 1.7% during the day but made up for most of the decline after the company reported results.

While the CPC and click volume story remains more or less the same, it is very good to see the strength in “Other” revenue, which is an indication of the effectiveness of its diversification strategy.

This is particularly significant given the growing challenges in its core search business. Not that its search business will go away any time soon (or at all), but the growing use of mobile means 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. In this environment, 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 $15.96 billion, which was a 3.5% sequential and 21.7% year-over-year increase, driven by stronger revenue from Google websites.

Revenue from Google-owned sites was up 4.5% sequentially, while that from partner sites was up 0.8%, resulting in a total advertising revenue increase of 3.6%. Both segments continued to grow (23.3% and 7.2%, respectively) from the year-ago quarter. Overall, Google-owned and partner sites brought in 69% and 21% of quarterly revenue, respectively.

Other revenue was up 2.7% sequentially and 52.6% year over year to around 10% of revenue. Management attributed the increase to higher Play Store sales (apps, content and chromecast).

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 1.8% sequentially and 9.4% from the year-ago quarter (down 40 bps and 202 bps, respectively as a percentage of advertising revenue).

TAC related to AdSense arrangements has been declining in recent quarters, although distribution-related TAC has been increasing steadily. The steady increase in distribution-related TAC is significant, as it is indicative of growing competition for the Google platform.

Net advertising revenue, excluding TAC was up 4.1% sequentially and 22.3% year over year.

Total revenue excluding total TAC came in at $12.66 billion, up 3.9% sequentially and 25.4% year over year, better than our estimated $12.35 billion.

The U.S. generated around 42% of Google revenue, down 0.5% sequentially and up 12.2% from a year ago. The U.K., with a 10% revenue share was up 2.5% sequentially and 22.7% from last year. Other international markets accounted for the balance, representing sequential and year-over-year increases of 7.4% and 31.1%, respectively.

Margins

The gross margin of 61.7% expanded 34 bps sequentially and 342 bps from last year, with the year-over-year improvement positively impacted by the exclusion of Motorola. Pricing remained a negative as explained above. The increasing contribution from the mobile and emerging markets, as well as growing distribution costs were other factors.

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

The cost per click (CPC) was flat sequentially with the 2% decline at Google-owned sites offset by the 3% increase at network sites. The 6% year on year decline was mainly because of the 13% decline in network CPC (Google-owned sites were also down).

This did however generate paid click growth of 2% and 25% from the two periods, respectively. Click volumes at Google sites were much higher (up 6% sequentially and 33% year over year). Network click volume growth was much slower at 5% and 9%, respectively.

Compare this with Yahoo YHOO search, where a 15% year-on-year increase in prices allowed for a mere 3% increase in paid clicks. So Google appears to be picking up a lot of lower-priced clicks that Yahoo is leaving on the table (note that Google seeing strongest growth in non-U.S, non-U.K. revenue).

Operating expenses of $5.58 billion were up 4.5% sequentially and 25.5% from the Jun quarter of 2013. The operating margin was 26.7%, flat sequentially and down 43 bps from last year. On a sequential basis, the higher R&D and S&M more or less offset the stronger gross margin and lower G&A. The year on year increase in R&D and G&A as a percentage of sales was more significant than S&M.

Non-operating gains were down significantly to $145 million compared to $357 million in the previous quarter and $236 million in the Jun 2013 quarter.

Google reported net income of $3.49 billion, or 21.9% of sales, compared to $3.65 billion, or 23.7% of sales in the Mar 2014 quarter and $2.86 billion, or 21.8% of sales in the year-ago quarter. GAAP earnings of $4.99 a share were down from $5.04 in the previous quarter and to from $4.77 in the June quarter of 2013.

Balance Sheet

Google has a solid balance sheet, with cash and short-term investments of around $61.20 billion, up $1.83 billion during the quarter. The company generated around $4.71 billion from operations in the last quarter and spent $1.61 billion on capex, netting a free cash flow of $3.09 billion. Google also spent $1.01 billion on acquisitions and generated $2.31 billion from the divestiture.

To Conclude

Google introduced “AdWords Enhanced Campaigns” last year, which enables advertisers to run each 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. The longer-term impact of the initiative should be positive because advertisers stand to gain. Also, despite the growing competition, it is significant that Google continues to see very strong volumes particularly from emerging markets.

Additionally, Google's initiatives in the ecommerce segment (both retail and payment platforms), its Google Fibre initiative, its Nexus, Chromebook and Chromecast platforms, the GDN and DoubleClick platforms, and the success of YouTube make it a power to reckon with.

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 even after the mobile revolution. Google's Android OS has gone a long way toward cementing its position in the mobile segment. Google has also made acquisitions over time that have augmented its in-house capabilities.

To top it all, Google has shown superb execution to date, which makes us optimistic about its future growth.

Google shares have a Zacks Rank #2 (Buy).