Google: 3Q Results Reveal Chinks in the Armor

| About: Alphabet Inc. (GOOG)

On the surface, Google (NASDAQ:GOOG) appeared to soundly beat analyst expectations of $4.76, by reporting diluted earnings per share of $4.92, on a top line of $ 4.04 billion (see conference call transcript). GOOG’s revenues were $20 million short of analyst expectations of $4.06 billion. This was the first time in GOOG’s trading history that they actually missed revenue estimates, and their sales gain amounted to a mere 4% sequential rise against second quarter results. The company’s growth rate is indeed in a declining phase, as the law of larger numbers, a dismal economy and a stronger US dollar are factors beginning to take their toll.

Market reaction: Wall Street was pleasantly surprised by the earnings release, rewarding the shares with almost a 12% markup in after hours trading. The shares saw nearly a $100 swing from their lows to their highs providing a nice selling opportunity for prudent traders. I think if you dig deeper into the report, you may detect some fool’s gold from within.

Major cost components analyzed: if you look at the Search Engine’s individual cost components, it is evident that Google was effective at keeping them in check. GOOG’s cost of revenue rose 31% from $1.66 billion to $2.17 billion, but was flat versus third quarter’s 2007 rate of 39.2% of sales. The company’s Research & Development component rose $156 million form $549 million to $705 million, but saw a 20 basis point decrease to 12.9% of sales. Selling & marketing costs increased 34% from $381 million to $509 million resulting in a 10 basis point increase from 9% to 9.1% of sales. General & Administrative costs escalated 28% from $321 million to $412 million, yet decreased 10 basis points to 7.4% of sales.

Income tax rate decline: Third quarter earnings were actually saved by a non-operational factor, a reduction in GOOG’s income tax rate. The rate decreased 370 basis points from 27.3% to 23.6% and enabled the company to save an additional $65 million. If you divide this savings by GOOG’s 318 million shares outstanding, the computation per share results in 20 cents. The bottom line is clear, if it wasn’t for the reduction in income tax, GOOG would of missed expectations by 4 cents, delivering earnings of only $4.72 versus the consensus of estimates of $4.76, and that would have been construed as a massive failure.

Google is tightening its belt: The company is going on the defensive. Goog’s capital expenditures dropped 35% for the quarter from $698 million to $452 million, and its hiring dropped substantially from about a 2000 employee hiring spree in the third quarter of 2007 to only 500 new hires this past quarter. The new talk of Microsoft acquiring Yahoo won’t help matters either. If these two finally get together, they could present formidable competition to GOOG, eventually chipping away at market share.

Bottom line: the shares have gone up almost 33% in a span of 8 hours , and are getting pricey once again. I would be a buyer on a 20% pullback after a correction takes place through normal profit taking. In the meantime, I would open a short position in order to take advantage of the impending decline, as the shares have simply gone up too much in too short of time, considering the rather tepid results that GOOG delivered if you factor in the income tax savings.

Disclosure: none