Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  
TRANSCRIPT SPONSOR
Tucows logo

Google Inc. (NASDAQ:GOOG)

Q2 2006 Earnings Conference Call

July 20, 2006, 4:30 pm ET

Executives

Kim Jabal - Director of IR

Eric Schmidt - Chairman of the Executive Committee, CEO

George Reyes - SVP, CFO

Larry Page - Co-Founder and President of Products

Sergey Brin - Co-Founder and President of Technology

Omid Kordestani - SVP of Global Sales and Business Development

Salar Kamangar - Vice President, Product Management

Analysts

Imran Khan - JP Morgan

Mark Mahaney - Citigroup

Anthony Noto - Goldman Sachs

Marianne Wolk - Susquehanna

Mary Meeker - Morgan Stanley

Bob Peck - Bear Stearns

Ben Schachter - UBS

Christa Sober Quarles - Thomas Weisel Partners

Safa Rashtchy - Piper Jaffray

Doug Anmuth - Lehman Brothers

Justin Post - Merrill Lynch

Heath Terry - Credit Suisse

Jordan Rohan - RBC

Denise Garcia - WR Hambrecht

Youssef Squali - Jeffries & Company

Mark May - Needham & Company

Presentation

Operator

Good day, everyone, and welcome to the Google, Inc. conference call. This call is being recorded. At this time I'd like to turn the call over to Ms. Kim Jabal, Director of Investor Relations. Please go ahead.

Kim Jabal

Thank you. Good afternoon, everyone. Welcome to our second quarter 2006 earnings call. On the call with us today are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Omid Kordestani, Senior Vice President of Global Sales and Operations; and Salar Kamangar, Vice President of Product Management.

Eric, George, Larry and Sergey will provide some thoughts on the quarter, and then we'll have Omid and Salar join us for your questions. Jonathan is not available to join us this quarter. Since we received such positive feedback on the format, we will try to keep prepared remarks to a minimum and allow more time for questions.

This call is being webcast through our Investor Relations website. Additionally, our press release, issued a few minutes ago, is now posted on the website. A replay of the call will be available within a few hours.

Some of the comments we will make today are forward-looking, including statements regarding future product innovations; the prospects for growth in online advertising, traffic and users; the seasonality of our business; the growth of our operating and capital expenditures; possible future compression in our margins; capital expenditures reducing our operating costs; our hiring patterns; our expected tax rate for 2006; and expected benefits from ad quality initiatives.

These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control.

These forward-looking statements speak as of today, and you should not rely on them as representing our views in the future, and we will undertake no obligation to update these statements after this call. Please refer to our SEC filings, including our report on Form 10-K for the quarter ended March 31, 2006 as well as our earnings release posted a few minutes ago on our website for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC, or by visiting the Investor Relations section of our website.

Also please note that certain financial measures we use on this call, such as EPS, net income, operating margin, operating income and free cash flow will be expressed on a non-GAAP basis, and have been adjusted to exclude charges related to stock-based compensation, or SBC, and a one-time gain from the sale of our investment in Baidu and the related tax effects of these items.

We also report our GAAP results, as well as provide non-GAAP results, on a supplemental basis in our earnings release. Reconciliations of all non-GAAP financial measures to GAAP financial measures are also included in the earnings release, which may be obtained by visiting the Investor Relations section of our website.

And with that, I'll turn it over to Eric.

TRANSCRIPT SPONSOR

Tucows logo

Tucows Inc. (AMEX: TCX) is the largest Internet services provider for hosting companies and ISPs. Through 7,000 partners globally we provide millions of email boxes and manage over five million domains. Tucows remains one of the most popular download sites on the Internet.

Tucows Inc. makes the Internet easier and more effective by reducing business complexity for our B2B and B2C customers as they acquire and deliver services to millions of Internet users around the world.

View our SEC filings, news releases, and learn more about our company and services.

To sponsor a Seeking Alpha transcript click here.

Eric Schmidt

Thanks very much, Kim. We're very, very happy with having such a strong quarter in a seasonally-weak period for us. It looks like our model continues to work extremely well; our focus on innovation, the many things that we've talked about with you all in the past. So thank you very much for joining us. It's another good day, a good quarter for Google.

When I look at why this is happening, I see the evolution of our strategy in front of us over and over again. We start with one thing, we learn, we iterate. That's the hallmark of how Google operates.

Today we are going to talk a little bit about some of the new products which are coming at a fast and furious rate. I'd also like to emphasize the role of partnerships. In your questions and comments, let's explore a little bit how the partnerships that we're developing -- not just the ad partnerships, which have been studied for many years, AOL and those sorts of things -- but a lot of the new partnerships. You can see how we're behaving with partnerships when you see the tremendously important Dell deal, Adobe deal, and others coming.

We're learning how to operate, learning how to build a stronger ecosystem. The strength of that ecosystem is central to our strategy, because we can't do it alone. We benefit by having the reach, impact, financials, and frankly, help from the partnerships, not just even the ones I named, but in content, in distribution and in access, all of which are announced with many, many more coming.

So with that, perhaps the best thing to do is to turn it right over to George to hear how did the quarter go, George?

George Reyes

Thanks, Eric. Q2 was another strong quarter in which we experienced robust revenue growth and made important investments, while continuing to grow our operating income.

Revenue was nearly $2.5 billion, representing growth of 77% over Q2 of last year and 9% over Q1. Google.com revenue was $1.4 billion, an increase of 94% over last year and 10% sequentially. Despite expected summer seasonality, growth in both traffic and monetization contributed to our performance this quarter.

Ongoing initiatives to improve the quality of our ads were a significant driver of increased monetization, along with continued healthy growth in our advertiser base.

AdSense revenue grew 58% over last year and 7% sequentially. Many of our AdSense research partners showed solid gains in monetization this quarter, while the continued expansion of our publisher base and increases in overall traffic drove growth in AdSense for content.

Revenue from the U.S. was $1.4 billion, or 58% of revenue. U.S. revenue increased 8% sequentially. International revenue was $1 billion, or 42% of revenue, and increased 11% sequentially.

Europe continues to drive most of our growth outside the United States, with the UK at 15% of revenue, or $370 million, up 8% sequentially. Germany continues to be our second strong market in Europe, but our investments in smaller markets are paying off. We saw double-digit growth in many countries, including Spain, Italy, Israel, Finland, Norway and Poland.

Outside of Europe, emerging markets in Asia and Latin America still represent a relatively small percentage of our total revenues, but continue to show strong revenue growth as we increase our hiring and investments in these regions. Traffic growth in Asia and Latin America was particularly strong this quarter. The World Cup did modestly impact traffic in certain countries, but did not have a material impact on revenues.

Foreign exchange impacted revenue positively this quarter, as revenue would have been $26 million lower in Q2 had foreign exchange rates remained constant from Q1 through Q2. Had foreign exchange rates remained constant from Q2 of '05 through Q2 of '06, international revenues this quarter would have been $18 million higher.

Turning to TAC, traffic acquisition costs were $785 million, or 32% of advertising revenue. The majority of TAC is related to payments to our AdSense partners. Toolbar distribution deals are typically accounted for as TAC if they are revenue-sharing in nature. In Q2, as in prior periods, TAC related to payments to distribution partners represented an immaterial percentage of advertising revenue.

Operating expenses included $107 million in stock-based compensation and totaled $652 million. These expenses included $342 million in headcount-related and facilities expense, as we ramped up hiring across our organization, particularly in sales and marketing and R&D; and $49 million in advertising and promotional expenses, including $24 million related to Toolbar distribution deals. We expect operating expenses to increase in the future due to continued aggressive hiring as well as marketing programs, including strategic distribution deals.

Non-GAAP operating profit, which excludes stock-based compensation, remains strong at $925 million, with non-GAAP operating margins of 38%, a sequential decline during this period of continued investment. As we have previously discussed, margins may decline as we continue to invest in the business.

In Q2, CapEx totaled $699 million. A substantial portion of CapEx was related to opportunistic real estate purchases of $319 million during Q2, about half of which was from existing lease conversions and half from investments to support future growth. The balance of CapEx was largely related to data center builds and infrastructure-related expenditures, including servers and network equipment, as well as data centers.

As we further improve and increase the sophistication of our core search and ads, we require customized infrastructure to deliver faster and better service to our users. The significant majority of our infrastructure spending supports our core search and ads platform, with the remainder supporting newer products and initiatives.

Our investments in core technology historically have paid off very handsomely for us in terms of our results. Rest assured that the decisions that we're making around capital expenditures are carefully thought out and prudently debated. Note that a significant portion of our CapEx spending is related to build versus lease decisions around data centers; and buy versus lease decisions around real estate. By making these investments upfront, we expect to reduce our overall cost of operations over the long run.

We noted during our last call that CapEx growth would be substantially greater than the annual revenue growth rate in 2006, and we continue to anticipate this going into the second half of the year.

Now, turning to cash, our balance sheet remained very healthy, with our total cash position standing at nearly $10 billion at June 30. Cash flow from operations was $841 million, and free cash flow -- which we define as cash flow from operations, less CapEx -- was $142 million. Q2 free cash flow was significantly impacted by the investments in IT infrastructure and the real estate that I just discussed.

Our effective tax rate for the quarter was 26% and 27% for the six months ended June 30th of 2006. We currently anticipate that our effective tax rate for the full year will be at or below 30%. We recorded a one-time gain from the sale of our investment in Baidu of $55 million. This and the related tax effect have been excluded from our non-GAAP calculation of income.

Turning to headcount, our headcount at June 30th was 7,942 an increase of 1,152 over Q1. While the majority of our hires are still in the U.S., the proportion of employees that are being hired internationally, particularly in India and Ireland, has been steadily increasing, consistent with our efforts to build our operations overseas and develop local products for local markets. We expect to continue to hire aggressively around the world, particularly in Q3, across all functions, especially sales, marketing and R&D.

In closing, I'd like to reiterate that we are pleased with this quarter, despite the seasonal impact on traffic. Looking ahead to Q3, we anticipate traffic levels will continue to reflect slower seasonal patterns, while we do expect to see continued benefits from ongoing ad quality initiatives in future quarters.

We will continue to make strategic investments to allow us to maintain our leadership position in search and ads and to pursue additional growth opportunities. Now I'll turn it over to Larry for more comments.

Larry Page

Thanks, George. We continue to focus on helping users worldwide to create designs and share information. We are focused on improving the user experience online and increasing the usage of Google products. This is how we measure our success.

We're excited that we will introduce many new products for international users this quarter. Localizing our products is an important step in broadening our reach with users worldwide and strengthening our brand and share in markets outside the U.S.

We delivered nearly 200 localized versions of products in this quarter alone, including Toolbar 4 in 15 new languages, Google Pack in 10 additional languages, Google News in Arabic, Google Talk in 13 languages, and the personalized homepage in four languages. We are also making international search a top priority by improving relevance and adding new features.

We are bringing more of our products to mobile phone users. Since there are at least twice as many mobile phones than PCs in use globally, and mobile usage is growing faster than PCs, we want to make Google available in a device-independent way.

Mobile phone users can now access Gmail, news and a personalized homepage in French, Italian, German and more. We launched Maps for mobile in several additional countries, and we are creating more opportunities for advertisers to reach users through mobile devices. We launched mobile ads in Japan in April, and the early results are very positive. We expect to roll out mobile ads in additional countries later this year.

We also made some great strides towards growing our developer community, a very important group of partners that will help us grow the Google user base. We also now have APIs available for many of our products, including AdWords, Blogger, Calendar, Maps, Gadgets, and Checkout. And partners like Salesforce.com, Cisco and SAS are now developing modules with the OneBox API for Enterprise to allow large organizations to search a wider range of corporate data through the Google Enterprise Search appliance.

We also continue to broaden our targeted branding solutions for advertisers. Many large and small advertisers are already taking advantage of click to play video ads on our content network, while auto companies like GM and Honda are running their TV ads on the Google network as a way to extend their reach from offline to online media.

Entertainment companies like Lions Gate and Fox are using Google for branding initiatives. For the release of the movie An Inconvenient Truth, Paramount Vantage selected hundreds of environmental news and independent film sites that they knew would reach their target demographic, and ran a two-minute trailer. The combination of targeted reach and video helped drive people to movie theaters. According to exit polls, over 30% of people who saw An Inconvenient Truth on opening weekend were exposed to Paramount's online ads.

Now I will turn it over to Sergey to talk some more about what we're doing for our advertisers.

Sergey Brin

Thanks, Larry. As Eric mentioned earlier, we continue to innovate in advertising. We introduced some very exciting products and services that allow our base of hundreds of thousands of advertisers to better target their ads and generate more sales.

We made it easier for advertisers to manage their accounts quickly and efficiently by offering AdWords Editor for free. We also introduced AdScheduling, which gives advertisers greater control over the timing of the delivery of their ads, and allows them to drive greater return on AdWords as a whole.

We are constantly making changes to AdWords to improve quality. We believe that by increasing ad quality, our users will continue to rely on ads to find the products and services they're looking for. We believe this is a win for everyone. Our users benefit by finding useful sites, advertisers benefit from qualified leads, and Google benefits from more long-term monetization opportunities.

In the quarter we made numerous changes to the way we serve ads that help us to show the best ad at the best time. For instance, one of our improvements involved showing fewer ads while users were looking for non-commercial information rather than seeking to purchase something, while showing more highly relevant ads when our users are searching for products and services.

Finally, we were very happy to introduce Google Checkout this quarter. We have spent a lot of time thinking about how we can help our users more easily shop online, while helping our advertisers generate more sales. Studies show that about 63% of users abandon their shopping cart before they complete the buying process. Google Checkout significantly improves and simplifies this process, while also benefiting merchants by delivering higher click-throughs, conversions, and ROI. We believe these benefits will increase advertiser spending and bring more advertisers to Google.

While we only recently launched Checkout, we have already received very positive feedback from users, and we are seeing very healthy adoption rates from all types of advertisers; from large offline retailers to small online merchants, including Buy.com, Bluefly, Starbucks, Back Country, and many more.

Eric spoke a lot about partnerships, and they will be very important to the success of Google Checkout. We are working with financial institutions like Citi Cards to co-market Checkout to their customers. We have also developed partnerships with e-commerce service providers like GSI Commerce, Monster Commerce, and Channel Advisor, to help merchants integrate Google Checkout into their website. We think this is one of the most exciting products we have announced this year, and expect to see great results in the near future.

With that, I will turn it over to Eric.

Eric Schmidt

Thanks very much, Sergey. As you can see, we're very, very proud of our results. A couple of themes that you hear through this. One, of course, is the rapid expansion of our international businesses. The world is a very big place and Google has very much a worldwide mission. You're going to see more and more international focus, international expansion, international growth.

Another is the investment in new products has continued apace. The primary investment, of course, according to our 70% rule, is in search and ads. When we talk about search -- we talk about search in everything -- and when we talk about ads, we talk about more than just the text ads. Indeed, we have many interesting trials, partnerships and new products in that space to offer even more advertising services to the audiences worldwide.

We are in a wonderful situation that we are able to now in fact increase the standards by which we select and hire new people into the Company. Currently we say we've raised the hiring bar. Even with that, we've been able to continue our expansion in headcount, especially internationally and outside the United States.

We talked a little bit about mobile and how important mobile is, and how so many people will ultimately be using mobile as their information source, and not just from an information perspective, but also from a monetization perspective, as we mentioned. We don't see any signs of approaching any limits to this vision. The opportunities before us really are unlimited at this point. So with that, I'd be interested in your questions, comments, thoughts.

Kim?

We're trying to get our operator on here. While we're doing this, we'll introduce Omid Kordestani an employee who runs all of our business operations. He's been on the call a few times; runs worldwide operations, customer service, all of our businesses, all of our deals. Welcome, Omid.

Salar Kamangar, one of the original inventors of the ad system, is here to talk a lot about the economics and structure of our advertising system. Do we have the operator?

Question-and-Answer Session

Operator

We do. (Operator Instructions) Our first question comes from Imran Khan - JP Morgan.

Imran Khan - JP Morgan

Hi everybody, good afternoon. Two questions. Eric, you talked about that one of your key goals is international expansion. If I look at international, could you give us some sense about the relevant fit quality of search in the international versus U.S., and the coverage in the international market versus U.S.?

Primarily we are more interested in the European market versus U.S. That would be very helpful.

Secondly, if I look at this last quarter growth rate, and if I ex out foreign currency, it seems like the U.S. and international growth rate was pretty relative. But it seems like U.S. is still growing pretty significantly the growth rate, while Europe is still very early. Can you help us understand what's driving the U.S. growth rate? Thanks.

Eric Schmidt

For part of the answer I can tell you that the quality in coverage in Europe is very similar to that of the United States. Depending on what assumptions we make about market share, we have strong market share in most of those countries, the brand is very, very strong. There's not much difference in user behavior, except, of course, the languages are different, but the quality there is very, very good.

The ad businesses are also very strong. Those are mature markets with strong e-commerce models, et cetera. With respect to overall growth rate, Omid, do you want to talk about that?

Omid Kordestani

Sure. In terms of business, yes, you're correct. We are seeing that our strategy is playing out really well in the United States and, frankly, the rest of the world. We are trying to leverage all channels of sales and operations effectively. People who are very sophisticated at using our ads and our APIs are now, in a lot of cases, directly interacting with our systems.

Our sales force in the fields in both regions, in all regions across the world, is working on opportunities with Fortune customers, with boutique customers, and also testing the new branding initiatives, off-site initiatives. So we are growing the base, we are leveraging all the sales channels, and then we are testing the new initiatives.

Imran Khan - JP Morgan

Thank you.

Operator

Our next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

Thank you very much. I wanted to ask about Google Checkout. Two questions: a financial question. Can Google Checkout be profitable for you as a stand-alone business, or are your assumptions that the knock-on effects related to more AdWords spending, higher click-through rates, that's what really makes it financially compelling to you?

Secondly, just in terms of the product itself, I know you talked qualitatively about some impact it's already having in the field with advertisers. Can you quantify that or provide a little bit more color? Are you seeing a material increase? I know it's early, but a material increase in ad buyers' budgets as they join up with Checkout? Thanks.

Eric Schmidt

Of course, the good news is things happen very fast at Google. But we've only had the product out for a couple of weeks, so it's very early to comment on it. We did Checkout to solve the problem that Sergey described, which is we simply want to make the whole process of buying just quicker, more foolproof, more likely to conclude.

We think that that ultimately will translate into higher value for the advertiser, which should ultimately be reflected in our overall revenue. But of course it's an indirect benefit. Salar, do you want to talk a little bit about Checkout?

Salar Kamangar

Sure. As Eric mentioned, everything about the product design, as well as the pricing model, is oriented towards helping users not just find the merchants and the ads, but also then complete the transaction. So it's for this reason that we have set up some incentives that have to do with AdWords spending.

Our goal is long-term to increase the amount of searches and commercial searches on Google, increase the click-through rates to our advertisers, and increase the conversion rates that these customers get because of increased convenience. So we're really thinking about the business as a way of adding to our overall ad network.

Mark Mahaney - Citigroup

Thank you.

Operator

Our next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. Eric, you talked about a lot of innovation. I was wondering if you could comment on the benefits from a couple of different things that were deployed during the quarter? The first is the number of sponsored links on commercial versus non-commercial terms. What have you learned from that in terms of benefits to the user and to the advertiser, and also buying?

Secondly, what benefits do you see in terms of increasing the reach of advertisers from launching vertical categories such as Google Finance? Does it allow you to increase your reach within that vertical type of advertisers? Thank you.

Eric Schmidt

Thank you very much. We're busy fine-tuning the ad network. And as you noted in the premise of your question, there is a set of commercial terms that we can trigger on. When we see those, we can do things that are even more valuable to the end user. If they're more valuable to the end user, it generates more value to the advertiser.

The most extreme form of that would be a specialized site like Google Finance, where we know the user cares a lot about finance. So it should be the case that an advertiser advertising on Google Finance would convert more highly, the revenue would be greater, the ads would have greater value, and should ultimately translate into more revenue for the Company, if the product is successful in the eyes of an end user.

So once again, it's end user value, targeting the ads, running these experiments with commercial versus non-commercial, then all of that generates, ultimately, greater return for Google. Next question?

Operator

Our next question comes from Marianne Wolk - Susquehanna.

Marianne Wolk - Susquehanna

Thanks. I was hoping you could talk a little bit more about what you're doing with the display advertising, and in particular where you are in your timetable with AOL.

Eric Schmidt

Omid.

Omid Kordestani

We are joining a lot of tests with different advertisers, different partners. As was mentioned during the call, for example, it was through the AdSense network we were running some of the click-to-play video advertising and evaluating the results of those tests.

With AOL, we have a very long list of milestones and projects that we are actively executing on, and we're on track with that partnership. So our hope is to really become a big player in this space. And we are doing a lot of tests, we're doing a lot of learning and fine-tuning our products.

Marianne Wolk - Susquehanna

Do you anticipate the display business being pay for performance?

Omid Kordestani

At this point it's probably easier for us to use our existing models, and if the option system is working very well, and the advertisers are familiar with that system and using it very well. We are very much open to testing different models as we learn, and adopt those if they make sense.

Marianne Wolk - Susquehanna

Thank you.

Operator

Our next question comes from Mary Meeker - Morgan Stanley.

Mary Meeker - Morgan Stanley

Thank you. Eric, you talked a lot about partnerships at the beginning of the call. And you obviously are in a unique position to set up win-win relationships with your partners -- you get them traffic; you give them a revenue share. Could you drill down a little bit more on your revenue share philosophy with some of these partners, whether it's Dell, whether it's Adobe, whether it's the mobile players?

A second question, you talked about your enthusiasm associated with the growth in video. Can you give us any qualitative or quantitative comments on rates of growth, degree of growth, percent of usage? Thanks.

Eric Schmidt

On the philosophy around our partnerships, we've typically given the majority of the value, if you will, to the advertiser, to the partner who brings the end user. So typically, in the structure we help drive, the majority of the revenue -- and the shares are pretty high -- goes to companies like AOL and Ask Jeeves and so forth. We get tremendous benefit, though from that, because then those advertisers are part of our overall advertiser network and so our Google.com property gets that benefit.

Although the specific terms with, for example, Dell are very much proprietary and part of a contract, we entered a similar arrangement with Dell after an awful lot of testing. The idea was that here's Dell, a very, very interesting, very, very important company, and their end users would benefit by having more access to Google. It's worth it to us to share that revenue in whatever financial structure makes sense, so that the end user is satisfied; Dell, of course, it's a good business for them, and it's a very good business for us.

So the answer depends on the kind of partnership. Is it a content partner? Is it a distribution partner? Is it an ad partner? Do they bring in users? What is the economic structure of their industry?

But all of them have some form of financial sharing -- although maybe not revenue, there may be other ways of doing it -- that gets them to where they need to be with respect to their economics, and gets our goals aligned. Omid, do you want to talk a little bit about the overall structure?

Omid Kordestani

Sure. As Eric mentioned, we really did exhaustive analysis on all these partnerships, really trying to understand the long-term value of those users, the incremental revenue they generate, and really build sophisticated financial models that bring value to our partner, as well as protect our long-term revenues, incremental revenues and market share. That's how we really struck all these partnerships.

In terms of your question about video, we really are focused on comprehensiveness here. We struck all kinds of partnerships, from Wimbledon to U.S. Soccer, Sundance Channel, UC Berkeley, and we're really focused not only on the tail of this and a lot of the uploading of videos from user-generated content, but a lot of premium partnerships as well.

Once again, we're doing a lot of learning here. A lot of new features are getting introduced, and we're also testing different ad formats to match this.

Eric Schmidt

It's worth adding, by the way, that internally when we did the strategy in this area, we said we are in the search business, so we need all of the information. We want to partner with people to get information so our search end users can see it.

We're also in the advertising business, and we'd like to provide advertising services to people who have their own proprietary content. So depending on where we are in that spectrum, we either do an advertising deal or a content deal or a hybrid deal.

But ultimately our goal at Google is to have the strongest advertising network and all the world's information, that's part of our mission.

Mary Meeker - Morgan Stanley

Thanks, Omid. Thanks, Eric.

Operator

Our next question comes from Bob Peck - Bear Stearns.

Bob Peck - Bear Stearns

With Yahoo!'s announcement the other day that they were clearing out some of their affiliates, could you talk a little bit about the impact of your new landing page quality score and what that's designed to do?

Number two, could you also talk a little bit more about your progress over at dMarc? When should we expect this to hit financially and see more news around the radio efforts?

Salar Kamangar

This is Salar. I will speak to the ad quality question. From the beginning, quality has been the hallmark of our ad system. The very first thing we did was to incorporate signals like click-through rate into the ranking method. Beginning at the end of last year, we saw that there was a problem where sometimes users would get great creative ads, but the landing pages that they'd be taken to were of lower quality. So beginning in last year, we began incorporating signals from the landing page into the ranking method and the final quality score.

We had another incremental launch in that spirit earlier this month, and we think the impact of that has been very beneficial to users. It has produced a small number of advertisers that were engaging in arbitrage and other methods that resulted in lower-quality ads, and as a result, has allowed us to show more ads from higher-quality customers. So we expect to keep evolving the quality signal to incorporate more information, including landing page data.

Eric Schmidt

On the dMarc question, we are in the process of introducing AdSense for radio, which is essentially the integration of the dMarc Console and management tools into our advertising network. The dMarc team itself is fully integrated. We're expanding it both in engineering and sales. We're also doing it worldwide, not just in the U.S. There's a number of very, very interesting deals being negotiated. They're on an integration schedule of about three months from now, so every week there are more milestones, and they're working very hard. It's very exciting.

Bob Peck - Bear Stearns

Thank you.

Operator

Our next question comes from Ben Schachter - UBS.

Ben Schachter - UBS

Congratulations on a very solid quarter. I was wondering if you could give us some insight into your interest in the healthcare field? Should we look for Google to focus on the consumers seeking information, on healthcare providers conducting business and organizing their information, or are there even broader aspirations in healthcare? Thank you.

Sergey Brin

We got an interest in healthcare primarily because there have been so many companies and organizations that actually have approached us interested in healthcare, how the kinds of technologies that we create could be used to help in their states, countries, and deal with various healthcare issues.

The first thing that we've done was a part of the launch of Google Co-op, where we improved the quality of our health search. We partnered with a variety of organizations. I'll probably get the list a little bit wrong, but I think it was NIH and MCBI and organizations such as that, CDC, to help us annotate and draw people towards more authoritative sources, or sources more appropriate to them as consumers or doctors, or healthcare providers of various sorts, just to improve the search.

I think that's a great product that's in its infancy, and we're very excited about it. It's also going to be used in other sectors as well.

But more broadly, we've seen that health information has a lot of similarities to the kinds of challenges we deal with in terms of just textual information. So we would like to make sure that for this important issue to many people around the world, of health, that we're actually able to contribute our technology to solve some of those problems.

We don't have a specific plan as of yet, but we're exploring a number of areas where we feel our technology could benefit people.

Operator

Our next question comes from Christa Sober Quarles - Thomas Weisel Partners.

Christa Sober Quarles - Thomas Weisel Partners

The first question centers on the embedding of conversion data into your ranking algorithms. How far along are you with that? Do you have a desire to develop a CPA product? It sounds like there was some mention of that during the quarter. Also if you could update us on your pay-per-call initiatives. Thanks

Eric Schmidt

Just to avoid any confusion, the search results from Google are not affected by the advertising business, and there is no relationship between what the advertising folks are doing with their ranking, their algorithms, the auction and so forth and what many people have called natural search, the normal Google results.

So with that, Salar, maybe you could talk about the ad part of this, and how we are using the new signals and so forth for both conversion data as well as pay-per-call.

Salar Kamangar

On the conversion side, what we've done to date is to put the information power in the hands of the customer through two products. One is a conversion tracking feature which they invoke from AdWords. Second is through the Google Analytics product, which is now incorporated fully into the AdWords interface.

We want this information to be available to customers in a very real-time manner so that they can immediately adjust their bids if they need to, based on changes in conversion rate information.

On the pay-per-call question, we think that's a very exciting area, because there's a large number of businesses, especially in the longer tail, more local businesses, that don't have need for sophisticated websites, and they rely primarily on phone calls that drive their leads.

We are now doing a small test with a product that we've been working on that's running on the content network, and we're going to keep evolving that and iterating it to improve the product until it's ready to be launched.

Christa Sober Quarles - Thomas Weisel Partners

Just a quick follow-up there. So, you are indeed embedding the conversion information that you're getting from Urchin into the prioritization of the ads, and then that's what's sort of helping you develop the CPA side?

Salar Kamangar

No, that's very different. That information sits in the hands of the advertisers, and they can adjust their bids if they like. Conversion rate signals are not affecting the ranking.

Christa Sober Quarles - Thomas Weisel Partners

Thank you.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good afternoon. Congratulations on a solid quarter. First, could you give us your assessment of if you're still gaining market share? And if so, what do you think is contributing to that market share gain?

Second, a question on the international front. It seems like two of the potentially largest markets, China and Russia, have posed some challenges where there are frontrunners and you are not number one. They may be one of the few countries where you are not number one.

Could you give us your sense of if you are seeing this type of local competition that has captured the top market share elsewhere? How do you plan to deal with these kind of local players that may be emerging? Thank you.

Omid Kordestani

Hi, Safa, this is Omid. I think Sergey and I are going to respond to you. We, first of all, believe in terms of the public data that's out there from research companies, we believe the data is directionally correct. Our internal estimates differ in terms of precision with that data.

In general we think we are doing really well in the United States and in Europe, and, as you mentioned, in some of those local more emerging markets for us, we have more challenges there. I think the equation there is one we are aware of how to solve. We need local engineering talent. We need local product innovation. We are busy trying to staff those operations.

Safa Rashtchy - Piper Jaffray

Do you think in the U.S. you are gaining market share? And if so, what's helping you with that?

Sergey Brin

This is Sergey. Maybe I'll take the rest of that. I think we've really accelerated the development of our products, specifically with respect to search. We're just devoting an enormous number of resources to it, and we've made tremendous strides in relevance and comprehensiveness, in ease-of-use, and freshness also. I think the end users really appreciate that and sympathize with that. I think our reputation has also grown with that. I think that's really helped here.

I wanted to talk a little bit about some of the other markets you mentioned, Russia and China. By the way, those are probably not the only two challenging markets for us. Also I would include Korea. There are probably a few others here and there. There have been some unique circumstances in each of those countries.

In China, for example, as you know, we have had some connectivity availability and latency issues. There are also some different product needs in that particular country. But we're now getting to be quite well staffed there, and have been addressing some of those and I think we're making good strides.

In Russia, which you know, I'm embarrassed to say we're not number one in, but there's a very strong company there, Yandex, which has been very talented. They've been doing search since 1990 or something. But primarily, Russia has some unique language features, which we've been addressing recently. Some of the recent rollouts have really improved our Russian language search quality, and I hope that will help us.

We've also recently opened an engineering office in Moscow, and for a short while we've also had a sales office there. I think we're going to really improve in those geographies and I hope we continue to improve in some of the others where we're not number one as well.

Safa Rashtchy - Piper Jaffray

Great, thanks.

Operator

Our next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

I just wanted to follow-up on some of the questions regarding Google Checkout and the CPA potential rollout. I'm wondering to what degree is Google Checkout a step toward a truly success-based pay-per-transaction search model down the line? Thank you.

Eric Schmidt

I think it's a very interesting idea. That's not what Checkout is today. Checkout is really a mechanism that allows people to more quickly buy products they want to buy. Roughly speaking, it remembers who you are, it provides a level of anonymity, and all of our testing indicates that people are much more likely to purchase from our advertisers if they have enabled Google Checkout.

Salar Kamangar

In our CPA trials, we are letting advertisers provide information to us through conversion tracking products that help us with the CPA tracking. But we don't have any plans right now to use Checkout information for anything outside of Checkout.

We have a lot of safeguards in place to make sure that the information from users is in their control. For example, Checkout lets users not share their full credit card information with merchants. It lets them not share their e-mail address with merchants. Instead it sets up an e-mail forwarding system. We will never rent or sell their information to other places. If we do anything further with the data, we will, as we always do, be very transparent with how we do that in a way that the user has control over.

Operator

Our next question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

The Google network revenues were up 58% year over year. Just wondering if you can help us understand whether the majority of the growth was from the strength of existing partners, or did you add several new partners on a year-over-year basis.

Secondly, can you just talk a little bit about the macro environment? Certainly, feedback indicates ROI from search has been very strong. With the economy potentially slowing down, how do you think that will affect search spending?

Omid Kordestani

This is Omid. In terms of your question about the partnerships, we are experiencing both growth from some of the key partners that are doing well, or they're promoting the content better.

So last quarter specifically, there were several partners that we renewed our partnership with and got better placements on their sites, as well as noticing them doing different implementations of their UI and spending more marketing promoting their sites. So we benefited from those factors.

So we're very much busy, both renewing these partnerships and expanding them. I don't think there was any significant new addition. It was a collection of the overall performance and some of these adjustments. And the other question, I think, Eric would like to address.

Eric Schmidt

On the question about what happens in a potential global economic slowdown to a very strong product like the ROI-based advertising we do, it's of course a matter of speculation what might happen. We do have some experience with this, which was after 9/11 in the United States. Again, the Company was much, much smaller, so I don't know if this is analogous. But a number of us were very concerned that everybody would just stop spending. And during that period, instead of stopping spending, people accelerated their transition to Google, which was, obviously, very positive, but also quite a surprise.

The reason was that when organizations are under stress, they focus on the best economics, because they don't have as many opportunities, they have to be much more careful. We continue to believe that the Google advertising system is literally the best place to put your sales dollars.

In a theoretical global recession such as what you were asking about, I'm sure that we would benefit by the fact that our performance is simply better than the other alternatives.

Justin Post - Merrill Lynch

Thank you.

Operator

Our next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

I was wondering if you could talk a little bit specifically about your strategy in Japan. Where is that business relative to, say, the service level that you've rolled out here in the U.S., and how do you view your market share progress there and strategy going forward?

Omid Kordestani

We've actually spent a lot of time on Japan recently, and very much interested in increasing our investments there. I think it's going to happen in multiple fronts. We are very focused on expanding our engineering and product presence there, as well as additional investments in our direct sales force, field sales forces, and service operations. The model is really working well there, and the economy is really improving there, and I think we just hope to be able to execute better to investments.

We also have been very successful with some recent partnerships -- the KDDI deal that we just announced; also with it had the launch of our mobile ads in Japan. We think, based on the early results -- it literally launched a day ago -- we are very optimistic about its performance. But we're excited about the market and we'll continue to invest in it.

Operator

Our next question comes from Bill Morrison - JMP Securities.

Bill Morrison - JMP Securities

I was wondering if you could from a high level, characterize or break down your sequential growth of 9% in terms of volume and monetization, if possible?

Secondly, I was wondering if you guys could comment on the net neutrality debate. You've been out there in front of this leading the charge for net neutrality. I was just wondering if you could give us the status of where we are at, how long it might be until there's some resolution.

I'm also curious if you've done any modeling or analysis, if net neutrality were to go away, what kind of an impact it might have on your margins? Thanks.

George Reyes

This is George. On the question you asked around monetization. Early in the quarter we put in place our usual rigor in terms of trying to identify product quality improvements that we could drive. Quite frankly, it was those product improvements that really helped shape the quarter to the 9% growth rate.

So we're pretty pleased with that, and of course many of the benefits that we incurred this quarter will spill over into next quarter. This is sort of an every day, every quarter thing, the way we try and drive ad quality improvements.

Sergey Brin

I wanted to discuss the net neutrality question. People, I guess, don't believe us when we say this, but we really care about net neutrality, not for Google as a company, but rather for all the small Internet companies out there.

We remember back in '98, '99, when we were a little company and the ability to play on equal footing with much larger companies, and have our service accessible equally around the Internet, was really a fantastic opportunity that really allowed us to build the Company.

Today, we have a fair number of resources at our disposal. We have partnerships with many of the big ISPs as it is. We have good relationships with them. We have a brand that end users are very attracted to. So I don't see it so much as us being affected by a hypothetical end of net neutrality, but rather all those other Internet sites.

Of course, being a search company, we really care about them. We want there to be a really healthy Internet ecosystem, and that's why we're fighting hard for net neutrality.

Eric Schmidt

Larry, you have some opinions about this as well.

Larry Page

I was just going to add, I think that we have a blessing with the Internet -- this amazing thing where you can connect to any country or any website, and it works pretty well, and there's actually expectation among all the ISPs and all the people who carry traffic for you that they do as good a job as possible.

There's been a very concerted marketing effort on the other side of this that the Internet is going to melt down or things like that. Actually, people have been saying that for the last 10 years, and it hasn't happened, because the Internet is an amazing, adaptive system, with many, many people making it all work. Engineers all work hard to make it work reliably, and it has been tremendously reliable and tremendously increased in speed.

We don't see any issues, we're delivering a lot of video. We don't see any issues with the video we're delivering, or any of the other services potentially having issues. We don't think that's an issue at all. We think the Internet will continue to grow tremendously as it is.

I'd also point out that it's largely been driven in countries like the U.S., where we have very poor last-mile connections for users, much slower than in countries like South Korea, which has spent less money and has much better connections, and haven't been pushing for elimination of net neutrality.

Operator

Our next question comes from Jordan Rohan - RBC.

Jordan Rohan - RBC

I was hoping you could give me a little bit of insight into the progress that's being made in mobile advertising? It seems like mobile advertising is an area of much promise, yet little advertising revenue worldwide.

Can you cite some examples -- and I realize they may have to be in Korean markets or Japanese markets, or areas outside the U.S. -- where mobile advertising is really helping to drive consumers into retail locations, and whether or not Google has been able to take advantage of that? Thank you.

Omid Kordestani

I mentioned this one earlier, where our partnership with KDDI in Japan is a really good example of us being focused on this space, and having very good results in the last day or so that we have launched the service. We do believe that we have tremendous advantage here. We understand search really well.

On mobile devices, the usage model is about finding information rather than browsing, and obviously, also the network of advertisers, which is very much global and strong. We can easily adapt that model to the mobile devices and make that network of advertisers flow into these different platforms.

So it's exactly what you said; we believe in this potential. Mobile devices are the primary usage device in a lot of these countries. The combination of search capability and the targeting abilities that we have, and the existing knowledge that we have, is going to really be a great advantage for us.

Larry Page

I was just going to add, there are significant sized markets now selling digital goods in places like Asia, which are things like ringtones and games for your phones and things like that, that are also being driven by advertising.

Operator

Our next question comes from Denise Garcia - WR Hambrecht.

Denise Garcia - WR Hambrecht

Congratulations on that impressive quarter. I was wondering if you could talk about new types of advertising platforms that you're moving into? I know we just got a question on mobile, but I'm also curious about video, and also the CPA program that you have.

You had mentioned that part of the strength in the Google model is that your advertising is priced on this ROI basis. I'm wondering if in these other platforms you might be pricing them on a CPM basis, or moving into other types of pricing strategies? And how that might affect your overall business as these other platforms grow, and how you see the growth there?

Salar Kamangar

We really have two different focus areas. One is, again, on the smaller advertisers, where our products like pay-per-call, we think, will make a big difference; as well as simplification of the AdWords system. We have launched several improvements to AdWords to make it easier for an advertiser to figure out which keywords to choose and figure out how to bid. The most recent thing was the AdWords Starter Edition, which greatly reduces the number of steps needed to get an advertiser on Google.

On the other side, we want to keep increasing both the ad types as well as the different placement areas for advertisers. One of the interesting things about our model is that advertisers often have set budgets that are much higher than we're able to deliver to. So it's really up to us to have fast quality improvements and look for new sources of inventory to help increase the number of customers to these businesses.

Larry Page

I just wanted to add, I think there's already starting to be a fair amount of complexity in how all the different kinds of customers we have and how they pay and which models they use and so on. I expect that that will continue, and we'll continue to have different products for different kinds of advertisers with different ways of paying.

I know there's a lot of talk about the CPA, or paying per purchase. One of the issues with that is people look around a lot before they buy something. So it's probably not the only information you want to look at when you're paying for advertising. But we're also excited about using more data like that in our models.

Operator

Our next question comes from Youssef Squali - Jeffries & Co.

Youssef Squali - Jeffries & Co.

Thank you very much. Eric, can you just speak to the success of your display product? I'm thinking particularly about site targeting, which didn't get much of a mention today. How big is it? In relationship to the overall growth of the business, did it grow faster or slower?

Second, George, you've spent, I guess by my math, about somewhere between $700 million and $750 million on what I would call maintenance CapEx in the first half of the year. Is that a good run rate for the year, understanding that obviously does not include some of the real estate investments you just made?

Omid Kordestani

Let me take the first part of that, which is the display advertising question and site targeting. We are actually very busy with our sales force approaching all of our customer base, and really going through the education process, the optimization, creating custom channels for these advertisers to reach the metrics and goals that they have. We are having success. It is not something that we can kind of broadly talk about yet. We are waiting to really gain more experience in different verticals from a different set of customers.

We have customers that are pretty big advertisers with us and they really like the results they're seeing, and the learning is really helping both of us expand here. So I agree, we haven't talked about it much. I think we would like to wait until we have more success under our belt and more customers, and more performance to talk about.

Eric Schmidt

Salar, you have an example of this.

Salar Kamangar

One of the more recent things that we worked on is on the video ad side. We already accept video ads in any format, convert them into flash, and display them in our network. One of the more recent things that we've released is a click-to-play video, where a user has a choice of clicking on the image, which will trigger a Google Video-based ad.

I think what's interesting about this is it's very consistent with the philosophy we have with all revenue advertising types. We want to make sure that it's something that adds value to the user, that it's something that the user is choosing to do. When you have this type of approach, I think it leads to higher conversion rates and higher satisfaction of the advertisers.

George Reyes

On your question around CapEx, Eric just had a wonderful suggestion, which is to blame it on Larry and Sergey, all this CapEx that we're adding. But realistically, we think we can't put too much CapEx into the system. It's a really critical part of our competitive advantage and our infrastructure. It's something that you're going to continue to see quite substantial investment going forward over the next few quarters.

Youssef Squali - Jeffries & Co.

No acceleration or deceleration?

George Reyes

There will be definitely an acceleration.

Youssef Squali - Jeffries & Co.

Great, thanks a lot.

Operator

Ladies and gentlemen, due to time constraints, we will take our final question from Mark May - Needham & Co.

Mark May - Needham & Co.

Thanks a lot. With regard to your partnerships program, and in particular the Toolbar distribution deals, I think you referenced that in your prepared remarks. Can you walk through the benefit of spending, for example, $24 million in a quarter for Toolbar distribution? How many incremental new customers do you estimate that you can acquire through spending that amount? What is the impact on usage and, ultimately, revenue from customers that you acquire through these agreements? That's the only question. Thanks.

Omid Kordestani

We will take a look at all of these deals very, very carefully and want to make sure that they are strategic for us. It is about giving users access to our search capabilities, and creating a more personalized browsing experience, and the various search access points that a user may have when they either purchase a PC or download a new application, that they get to have access to our services, and not only grow our search market share, but protect it.

As I mentioned earlier, in all of these deals, we do a very sophisticated set of analysis on understanding the long-term value of the user to us, the incremental revenue we are generating, or in some cases the kind of revenue that we may be cannibalizing; and really take all of those factors into effect, and make sure that this makes business sense for us and ensure that revenue with the partners.

Larry Page

I was just going to add, this may be acknowledged by some of our competitors, we have very, very strong monetization on search. This gives us a nice benefit when we're negotiating these kind of deals to make them both a win for the partner and for us.

Eric Schmidt

Thanks Omid, thanks Larry, thanks Sergey, thanks George, thanks Salar, thanks Kim. We've reached the end of our time. I wanted to make sure that at the end of this call we emphasized that Google really is committed to providing the best end user search experience worldwide. That's not just on PCs or Macs; it's on every device against every piece of content.

We're going to continue to get better and better at providing the best and most relevant search. It is the core part of what we do. We use feedback from customers, as we test our products, and we're always going to stay true to that with respect to the products that we have now and the many, many products coming up in the future. So with that, thank you very, very much.

Operator

That concludes today's call. Thank you for your participation. You may disconnect at this time.

TRANSCRIPT SPONSOR

Tucows logo

Tucows Inc. (AMEX: TCX) is the largest Internet services provider for hosting companies and ISPs. Through 7,000 partners globally we provide millions of email boxes and manage over five million domains. Tucows remains one of the most popular download sites on the Internet.

Tucows Inc. makes the Internet easier and more effective by reducing business complexity for our B2B and B2C customers as they acquire and deliver services to millions of Internet users around the world.

View our SEC filings, news releases, and learn more about our company and services.

To sponsor a Seeking Alpha transcript click here.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Google Inc. Q2 2006 Earnings Conference Call Transcript (GOOG)
This Transcript
All Transcripts