Google Won't Be Able to Defy the Recession

“Google Defies Economy to Beat Forecasts” - Reuters 

Google (GOOG)…defying the economy? Impossible. Even the mighty search giant won’t be immune to this recession. They’ve just been able to avoid the fate of competitors so far.

The real problems will get to them. I expect the economic downturn that is just starting to show up in advertising budgets will make its way across all businesses that live off advertisers, including Google.

For the moment, Google isn’t defying anything. The company’s recent earnings release was a strong one, but the growth and improved performance isn’t coming as a result of the economy. It’s more of a result of a structural change in the advertising industry and a little belt-tightening by Google.

The last year has been a fairly strong one for Google. The Internet search giant saw its total revenue climb 31% which led to a 25% increase in net income compared to the same period last year. The headline numbers look good.

If we delve under the headline numbers, however, a bit of a different story appears. Take a look at the operating margins. Operating margins provide one of the best pictures of how healthy a company is. A business that can generate more dollars in profit while growing top line revenue is in very good shape. You can see that in the operating margin.

Google’s operating margin has been in a steady decline since Q3 2007. As you can see in the chart below, the decline may have been relatively slow, but any decline should start to raise some concern.

Google Operating Margin
Q3 2008	Q2 2008	Q1 2008	Q4 2007	Q3 2007
31.4%	29.4%	29.8%	29.8%	31.2%

 In this case Google appears to be getting healthier. The Internet search giant’s operating margin increased despite expected cuts in corporate advertising budgets. The increase appears to show that Google is as healthy as it was a year ago, but the increase actually came from Google significantly cutting costs.

Google sees what is going to happen to advertising revenue during the recession and is finally reigning in its costs. Google’s selling, general, and administrative [SGA] costs declined for the first time in over a year last quarter.

The company known for providing free coffee, meals, and snacks to its employees is starting to cut back on a few of the perks. Last quarter, Google slashed SGA costs, which rose from $702 million in Q3 2007 to $959 million in Q2 2008. That’s a 36% increase in SGA costs in 12 month's time.

It was too much too fast. Granted Google, was growing quickly, but SGA costs were growing even faster.

In the chart below, you can see Google SGA costs as a percent of total revenues. Some cost increases should be expected, but on a comparative basis, they were getting a bit too high. In Q3 2008 the uptrend was reversed and Google made some necessary adjustments to prepare for the recession.

Selling, General, & Administrative Costs (% of revenues)
Q3 2008	Q2 2008	Q1 2008	Q4 2007	Q3 2007
16.58%	17.86%	16.51%	16.55%	16.59%

And it’s paying off in more profits and improved operating efficiency. The biggest rewards from these cutbacks will be reaped over the long-term.

Google’s cutbacks are a very, very good move right now. A company that generates so much free cash flow, $8.3 billion cash ($17.9 billion in total current assets), and practically no debt will be in perfect position to capitalize on the upcoming recession.

Google has made significant inroads into the Internet search engine market. Its market share sits at 63% of all web searches. Now, with a pending partnership with its formerly formidable competitor Yahoo! (YHOO), its market share of Internet advertising revenue is going to continue to grow.

For the time being, that market is starting to slow a bit. Bloomberg reports: 

The credit crisis may cost the online-advertising industry $6.7 billion in lost sales through 2010. The reductions (in online advertising) will drive growth in U.S. Internet ad outlays to less than 20 percent next year for the first time since 2002.

Total Internet advertising is expected to increase to $43.6 billion. That’s well short of the previously expected $44.4 billion.

As we can see, Internet advertising isn’t going away, but it will not grow nearly as fast as it did. This is a recession, and every company will be impacted in some way. Leading advertisers like General Motors (GM) and financial services companies like T. Rowe Price (TROW) and Wachovia (WB) have either disappeared or will have to trim their advertising budgets.

When all is said is done, Google will not be able to defy the recession. It will be impacted. There will be a great time to load up on shares of Google. The company will survive the recession and will be one of the few companies that come out stronger on the other side, but immediately after a solid earnings and news report is probably not one of the best times to buy.

If this will truly be a “long and deep” recession as predicted by Prem Watsa, the excitement around Google will fade and there will be a time to buy even cheaper shares of Google.

Good investing.