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Google (NASDAQ:GOOG)

Q2 2009 Earnings Call

July 16, 2009 4:30 pm ET

Executives

Maria Shim - Investor Relations

Patrick Pichette - Chief Financial Officer, Senior Vice President

Eric E. Schmidt Ph.D. - Chairman of the Board, Chief Executive Officer

Jonathan J. Rosenberg - Senior Vice President - Product Management

Nikesh Arora - President - Global Sales Operations and Business Development

Analysts

Imran Khan - J.P. Morgan

Mark Mahaney - Citigroup

Justin Post - BOA Merrill Lynch

Christa Quarles - Thomas Weisel Partners

Benjamin Schachter - Broadpoint Amtech

James Mitchell - Goldman Sachs

Sandeep Aggarwal - Collins Stewart

Youssef Squali - Jefferies & Company

Doug Anmuth - Barclays Capital

Spencer Wang - Credit Suisse

Jeffrey Lindsay - Sanford Bernstein

Jeetil Patel - Deutsche Bank

Heath Terry - FBR Capital

Steve Weinstein - Pacific Crest

Jim Friedland - Cowen & Company

Operator

Good day and welcome, everyone, to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the conference over to Ms. Maria Shim. Please go ahead, Madam.

Maria Shim

Good afternoon, everyone and welcome to today’s second quarter 2009 earnings conference call. With us are Eric Schmidt, Chief Executive Officer; Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President of Product Management; and joining us for the first time, Nikesh Arora, President of Global Sales Operations and Business Development. Eric, Patrick, and Jonathan will provide us with their thoughts on the quarter and then Nikesh will join us for Q&A.

This call is being webcast from our investor relations website located at investor.google.com. Please refer to our website for important information, including our earnings press release, issued a few minutes ago, along with slides that accompany today’s prepared remarks.

A replay of this call will also be available on our website in a few hours.

Please note that we routinely post important information on our investor relations website, located at investor.google.com, and we encourage you to make use of that resource.

As a reminder, we are holding two calls today. On this call we will discuss our strategic overview and Q&A with the usual format, followed by a second call which is effectively an extended Q&A session with Jonathan and Patrick, giving the opportunity for participants to ask more detailed financial and product questions in an efficient and reg FD compliant manner.

The second call will begin at 3:00 P.M. Pacific Time and will also be webcast from our investor relations website.

Now let me quickly cover the Safe Harbor -- some of the statements we make today may be considered forward-looking, including statements regarding investments in our core business and innovation, expected performance of our business, and our expected level of capital expenditures.

These statements involved a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008, as well as our earnings press release for a more detailed discussion of the risk factors that may affect our results. Copies 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 the call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation.

We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow.

Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release.

With that, I will now turn the call over to Patrick.

Patrick Pichette

Thank you, Maria. Good afternoon or good evening, everybody. What we will do is we will have our regular schedule, so Eric will give us his comments first. I’ll cover the financial portion and then Jonathan will give us a product update. As Maria mentioned, we also have Nikesh with us and then we will turn it to Q&A. So without further ado, I’ll let Eric introduce.

Eric E. Schmidt Ph.D.

Thank you very much, Patrick. So Google, we’ve had a good quarter, one that demonstrates our resilience in what continues to be a very difficult environment, 3% year over year growth, as you have seen from the press release.

Google as a business appears to have stabilized despite the still weak economic environment. Advertisers and customers are obviously seeing the benefit of the performance-based advertising that we offer and consumers are clearly using search more and ever to find the best deals.

We’ve also implemented careful cost controls to help our performance. Making our business more efficient has been our goal for the last few quarters and it should put us in a good position to benefit from the eventual recovery whenever that occurs. And we are going to continue to invest in innovation. History shows that companies which invest in innovation during downturns emerge stronger than the cost-cutting competitors and it’s easy for big companies, Google is now a large company, to become conservative to take small steps when they need to take really big ones, so we are determined not to make that mistake.

And as an example, you don’t change the world incrementally. You do it through big innovation and the ability to execute on your ideas. So for example, we just announced Chrome OS for netbooks, our effort to rethink what an operating system should be, based on our lightning fast browser technology, Chrome, which people are already using. We need a faster operating system for the same reason we need faster browsers -- people are now doing everything on the web and this will be an operating system built around ubiquity and the power of the Internet.

And innovation, of course, is not just new products like what we talked about last week. It’s also the key to long-term growth in our core and our new businesses.

In our core business, search is still an unsolved problem, even though Google is working very, very hard on the next generation of search -- more social, more personal, more intelligent, we did more than a hundred search quality improvements in the second quarter and users are now coming to us with increasingly more complex questions and queries.

We’re getting much better at finding the exact information and content people are looking for. We just introduced, for example, Google Square which automatically fetches and sorts facts and data from across the web on a given topic. We now actually have another feature called Search Options, which Jonathan is going to talk about.

In ads, strides in ads quality and sales drove healthy revenue growth despite a tough economic environment. Our ads keep getting better as we’ve developed new ways of identifying high quality and relevant ads. We’re experimenting with innovative ad formats for search, particularly in the areas of local, products, and video, which should help us a lot in some of these new businesses.

And on the sales side, we’ve been much, much more rigorous in terms of our management, in terms of our measurement in focusing our resources in the highest potential areas. For example, advertiser acquisition and better tools to identify the largest opportunity for individual customers. Of course, Nikesh has been driving that.

And in our new businesses, it’s also a good story -- display in particular, including YouTube, performed very well this quarter. YouTube is now on a trajectory that we are very pleased with and we are helping marketers and agencies create great ads easily. For example, the Double-Click Studio, tools which allow customers to build end-to-end rich ad campaigns.

In mobile and android, another area of innovation in new businesses, mobile devices are becoming an extension of the Internet. We all know this. And more and more Google searches are coming from mobile phones of all kinds. So we are focusing to innovate in this space. So for example, we’ve done great news with Android, with somewhere between 18 and 20 Android powered phones on the market by the end of the year, which is phenomenal.

Even in the enterprise, we’ve been able to have significant Q2 deals. The mobile handset division of Motorola has moved all 15,000 users to Google. Seventy-five new schools for apps education in the second quarter. Temple University, University of Massachusetts at Amherst, University of Alabama, the list goes on. And we’ve now deployed against, for example, 30,000 employees at [Voleyo], which is an automotive company, Johnson Diversity, a cleaning product manufacturer, another 10,000 employees. So the model is beginning to work.

To put this in perspective, we are very pleased with our year-over-year performance, particularly in light of the still weak economy and the economic situation continues to be tough, as we all know. We saw relative stability in our business in the second quarter. It’s too early for us to tell when the recovery will materialize. I wish we could just prove it, you know, we could do the analysis and figure it out but we don’t know how to do that yet. So when the recovery does come, and it always eventually comes, we are very well-positioned for the future, given our constant and continuing investment in innovation.

So with that, Patrick, thank you very much. Go ahead.

Patrick Pichette

Thanks, Eric. Good afternoon, everyone. So I’ll take a few minutes to run through our results.

We are pleased of our performance in Q2, showing solid revenue growth and good expense management, especially in the kind of environment that Eric portrayed. Our gross revenue grew 3% year over year to $5.5 billion. We saw relative strength across our business, despite a weak macroeconomic environment and a dollar that is still quite strong compared to last year. In fact, if we applied last year’s exchange rates to our Q2 revenue, these would have been roughly $500 million higher. So fortunately, we have recognized $124 million of benefits from our hedging program to partially compensate.

Google.com was also strong, contributing the majority of the total year-over-year growth. It was up 3.5% year over year to $3.7 billion, with continued healthy traffic growth and we saw signs of strength in certain consumer verticals, such as shopping and computer and electronics. Others, such as finance, continued to be relatively weak.

In Q2, we also benefited from a number of ads quality launches. Ad sense was up 2% year over year to $1.7 billion. In Ad sense for content in particular, we saw solid results, our smaller partners performed well and our display business experienced strong year-over-year growth as well, and I’ll let Jonathan and Nikesh talk about more about these successes.

Our global aggregate paid click growth remained healthy. They were up 15% year over year, even if down 2% quarter over quarter for seasonality. Aggregate cost per click growth was down 13% year over year but up 5% quarter over quarter. Again, FX clearly had a negative impact on our year-over-year growth but a positive impact quarter over quarter due to the weakening of the U.S. dollar versus the first quarter.

Turning to our geographic performance, the U.S. had revenues up 2% year over year to $2.6 billion. International revenue accounted for 53% of our total revenue, or $2.9 billion. The U.K. was down 8% year over year to $715 million, and was clearly negatively impacted by the FX, as well as ongoing macroeconomic weakness. This is partially offset by revenues from our hedging program.

Let me now turn to expenses -- traffic acquisition costs were $1.5 billion, or 27% of total advertising revenue. Other cost of revenue was $655 million, which included $14 million in stock-based compensation. And all other operating expenses totaled $1.5 billion, including approximately $279 million in stock-based compensation again.

On a year-over-year basis, our OpEx was lower by nearly $120 million and flat quarter over quarter. So as a result, our non-GAAP operating profit, which excludes the stock-based compensation, increased to $2.2 billion in Q2, compared to $1.9 billion last year and our resulting non-GAAP operating margin of 39.2%.

We are really pleased that we’ve been able to manage our costs prudently while fully funding our strategic growth areas in search, display, mobile, and apps. Again, Jonathan is going to go into more details of our initiatives in these areas in a minute.

Turning to headcount, we had approximately 20,000 full-time employees at the end of Q2, down approximately 375 from the end of Q1. Even though we continue to hire in many areas of our business in Q2, we ended up with a decrease primarily related to the reduction in the sales and marketing positions we had announced you’ll remember at the end of Q1.

Let me now turn to cash management -- in other income and expense, we had a net expense of $18 million for the quarter. As I talked to many of you on the last call, we manage our cash very responsibly. For the past year, and again for most of Q2, we’ve been focused on capital preservation and we believe that this was obviously the right thing to do, given the recent macroeconomic environment. So in consequence, this means we realized lower yields on our investments.

Our realized gains on our marketable securities were $18 million and once again this quarter, the high volatility relative to the options strike prices required us to accelerate our hedging expenses, as per the FAS-133 rules. The impact on OI&E on our FX program was roughly equivalent from last quarter.

So as I mentioned earlier, we did however continue to recognize benefits from this hedging program while we also benefited from a slightly weaker U.S. dollar during Q2 versus Q1.

Our cash flow hedging program allowed us to recognize a benefit of approximately $124 million to international revenue this quarter.

Our effective tax rate was 20% for Q2. Let me remind you that any change to the mix of earnings between domestic and international subsidiaries, as well as the effect on earnings of various hedging activities and the related hedged items, do have an effect on our tax rate.

Operating cash flow was very strong at $1.6 billion. CapEx for Q2 was $139 million. While the recent trend in CapEx has no doubt been declining, remember that we will continue to make investments, and significant ones in CapEx in that it is simply lumpy from quarter to quarter, depending on the timing on when we are able to make these investments.

Finally, free cash flow was also strong at $1.5 billion.

So in summary, we are pleased with our Q2 results, especially despite the expected seasonality, the economic situation, and our year-over-year FX fluctuations. It’s clear we are able to be disciplined about our costs but while staying really focused on fully investing on the big, long-term opportunities that we see in our core business, display, mobile, and apps.

Finally, and also important to note, I would just like to remind everyone, as we do every year, that Q3 also tends to be impacted by summer seasonality.

With that, I would like to thank you for your time and I’ll turn it over to Jonathan for his thoughts on the quarter. Jonathan.

Jonathan J. Rosenberg

Okay, thanks, Patrick. So I want to highlight the key launches this quarter and try to give them context with some of the principles that drive our innovation efforts. If you’ll recall, going back to the founders letter from our IPO in 2004, we’ve always said our focus is on users. Today, user interest still drives pretty much everything we do but recently, we’ve become a lot more focused on what we call the active power users.

What we’ve seen is that power users in search are getting a lot more sophisticated, so they are running more complex queries. They end up typing in longer queries than they used to and their expectations today are much, much higher. If you actually think about search, five years ago people were just delighted when they googled what they wanted and they found it but today, they actually get upset when they don’t get what they want. So that’s a really big difference.

So to better server power users, we launched our new search options feature, and what that does is it lets you slice and dice search results in different ways, like by time or type of result. If you click on the show options link, which you’ll find at the top of a search result, you’ll get a sense of just how that innovation drives usage.

We also have a basic user principle that fast is better than slow and we’ve told you this before and that it’s critical for search and our engineers continue to focus on reducing search latency throughout the world but speed is actually also key for all of our other products.

We launched a number of improvements with Picasa in Q2 and one of them lets you run a slide show of the pictures that you’ve uploaded to the web, and it does it as quickly as if the pictures were stored on your computer. You can see this if you go to a large online album and you just rapidly bang on the right arrow key. That’s basically what I did when the team told me they were ready to launch. So try it -- it’s cathartic to hit your keyboard. Just go bang, bang, bang, bang, bang on the arrow key and you’ll watch on the screen and you’ll really see viscerally that apps running in the cloud can actually be as rich and as powerful as apps on your desktop.

We also have a policy of ship fast and iterate often, so we redesigned Google Labs and our engineers have been releasing new labs features about twice per month. Fusion tables, Google Squared, similar images are a few from Q2.

Gmail is also another example where we are shipping and iterating. We are pushing out roughly one new feature a week -- things like automatic message translation and my team gave me a long list of other features to list, but let me just repeat -- automatic message translation. Stop, think, and try that. It’s actually a pretty big deal. Also, our entire suite of apps products is robust enough that we took it out of beta last week.

We also run product development by encouraging teams to make big product bets on key technical insights. We believe that our most innovative products historically, if you consider say search, maps, Gmail, news and Chrome, all of them are based on technical breakthroughs, or BETS. Recently we’ve become bullish on a new emerging standard called HTML 5 and it’s helping to make the web the platform for very powerful and rich applications. It’s especially important in mobile where the high-end phones with very rich browsers are becoming the norm.

And this quarter, we launched mobile versions of Gmail and mobile web maps that run in the browser using HTML 5. Their performance really is remarkable.

We believe that the runway to innovate due to the power of computers on these mobile devices is nearly unbounded at the moment. We are also making another technical bet with Google Chrome OS. A whole new generation of web-based apps demand a much better, faster user experience and once you have all your stuff online, you ought to be able to just open up your computer and get there in a matter of seconds.

We are also innovating and driving monetization with mobile and YouTube as well. Mobile monetization picked up a good bit of momentum as search traffic grew, again driven mostly by the smartphones. And we’re seeing that users on these high-end phones are very active and engaged beyond search, so display advertising on those phones is actually emerging as an interesting mechanism.

On YouTube, monetized views have more than tripled in the past year. We’re now monetizing billions of views of partner videos every month and we are actively promoting featured partner videos on all the -- on the home, watch, and search pages.

Of course, one of our most innovative areas is ads quality and we shipped more than a dozen improvements there this quarter. That’s kind of a typical pace that I usually share with you but in terms of our PM impact, it was a pretty strong set with a higher impact than usual.

Finally, we always want to make the web better. We believe that what’s good for the web is good for Google and email is obviously a web application that generates a lot of usage. So a while back, we asked the question, what if email were invented today? And as you know, the answer there was Wave, which is a totally new way to communicate and collaborate online.

What we did there was rather than having our Gmail team work on this, the whole product was conceived and developed by a small team in Australia. They worked completely autonomously. They called the project Walkabout and the product received a standing ovation at our recent developer conference.

Android, Chrome, Wave, and Chrome OS are all open source. This kind of open innovation helps us create the next generation of breakthroughs, and when I say us, I don’t mean Google, I mean the larger community of creative web developers. The more power and tools that we put in their hands, the more innovation we know we are going to see on the web and that benefits users around the world and we think makes the pie bigger for everyone.

So with that, back to Patrick.

Patrick Pichette

Thank you, Jonathan. So what we’ll do now is we’ll turn it over to the Operator and we’ll set up the call for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Imran Khan from J.P. Morgan.

Imran Khan - J.P. Morgan

Two questions -- one on the mobile application side, I think you talked about that the mobile search volume has increased significantly. Could you help us understand the revenue per search difference on the mobile versus the web and do you think it will cannibalize your search on the desktop?

And secondly, with -- some could argue that Google [inaudible] its search market share through some of the distribution deal like Ask and AOL. Considering one of your competitors launched a new search technology, how worried are you that they could be potentially aggressive to win back some of those distribution deals and how aggressive you will be to make, hold back to those distribution deals?

Eric E. Schmidt Ph.D.

Imran, thanks for your questions. On the mobile search side, one of the key things we’ve done in the last few months is we’ve started to show the desktop ads. It turns out that the separate mobile ads have their own formats. Typically there wasn’t enough demand, there weren’t enough kind of creatives and so forth. So we started showing the desktop ads on the mobile browsers of high quality and these of course include the iPhone and the Android phone and anything that’s a web-kit inspired browser.

All of a sudden we started seeing a tremendous number of searches and also very good click through rates. So they monetize at a similar level, if they are desktop-based because of course they are in the same auction.

It makes sense over time that those ads should perform better than on PCs because on a mobile device, we know more about the person and we could have an even more targeted ad but we don’t do that today.

Jonathan J. Rosenberg

The other thing that I would say, you asked specifically about cannibalization -- I don’t think there really is a cannibalization dynamic. We see that mobile searches tend to complement desktop volume. Mobile goes up when people are away from their desk, so weekend tends to be higher for mobile traffic. And of course, the reverse is true for the desk top.

On the second question, I think it’s kind of too early to tell from a market share perspective what’s going to play out in the long run. We certainly haven’t seen any large shift in share to date.

Imran Khan - J.P. Morgan

Thank you.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Mark Mahaney.

Mark Mahaney - Citigroup

Thank you. Also two questions -- Eric, you mentioned you think the business is stabilizing. What are one or the two most important things that you look at to make that call as to whether business is stabilizing or not?

And then for Patrick, there’s a lot of cost efficiencies that have been gained over the last couple of quarters. Can you talk to us about what the cost structure looks like coming out of the recession, whenever that is? To what extent should we believe that the cost efficiencies will stay in place post the recession? Or is this more temporary efficiencies? Thank you.

Eric E. Schmidt Ph.D.

On the stabilizing question, a quarter ago, we had no idea where the bottom was. We started off the year and all of a sudden our metrics were off and it became clear that starting roughly Christmas, people were spending more time searching and when they purchased products, they were purchasing products of less value. Furthermore, when they did so, the whole process just took more time.

It appears as though, although the RPMs have not fully recovered, the other aspects of behavior have in fact come back. And with the notable exception of the financial vertical, the other verticals in particular, shopping and travel, which had been significantly affected, appear to be recovering.

So some of those tells us to say the word stabilizing. We’re not at the moment looking at that downward spiral that we thought we might see six months ago.

On the second question, let’s ask Nikesh to offer some perspectives on how this is playing out.

Nikesh Arora

Just to add to what Eric has already said, if you look at it from a geographical basis as well, we are seeing stabilizing in some of our key markets around the world. Also from an advertiser point of view, earlier in the year there seemed to be more uncertainty amongst advertisers who seem to now have come back and continue to go back and bid for major categories, major verticals. The small advertisers have stayed pretty much consistent throughout this process because they are very ROI focused. They understand the value of search, they understand what they are investing for. Large advertisers had sort of watched and wanted to watch and wait for a while have seem to have come back to the table and that’s where we are seeing the stabilization from the advertiser side as well.

Patrick Pichette

So that covers the first question. Let me jump on the second one -- I think we can be really proud at Google about how googlers have managed responsibly in the last two, three, four quarters if you think of everything that the economy has thrown at us. We’ve managed to keep the right balance between the Google culture of being frugal but generous environment. That’s really what portrays the place and we didn’t lose our magic around that.

And most of all, I think that we are managing the company to best position itself for the long-term growth. So it’s clear we are able to be disciplined about costs but at the same time, fully investing in our long-term opportunities.

So I think that what we can take away from the last few quarters is we have that ability and we continue to manage it that way so we have the flexibility we need.

We’ll go to the next question, please.

Operator

And we’ll take our next question from Justin Post from BOA Merrill Lynch.

Justin Post - BOA Merrill Lynch

Thank you. My question is on paid clicks and CPCs -- first on CPCs, it looks like if we back our currency at $44 million, they were up 4% quarter over quarter and is there any kind of sign of stabilization in that number or is that due to mix and seasonality? And the second thing is paid clicks, 15% growth -- could you talk a little bit about the mix? Are the higher value clicks in say the U.S. and U.K. growing slower than maybe some of the lower value clicks internationally? Could that be a long-term CPC pressure or are paid clicks growing pretty even across your entire system? Thank you.

Jonathan J. Rosenberg

Just to comment on the clicks across the system, I think the growth is more seasonality and mix. One of the things that we see is that Brazil and China, for example, are pretty significant and probably have disproportionately more clicks. So I think we are seeing a mix of clicks from the high CPC Western European countries and U.S. being less relative to some of the growing markets. So that overall is having downward pressure on CPC.

I think the bids tended to decline more earlier this year and are declining -- are no longer declining now as a general rule across the board.

Justin Post - BOA Merrill Lynch

Thank you.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Christa Quarles from Thomas Weisel Partners.

Christa Quarles - Thomas Weisel Partners

My question is on vertical search in the context of Twitter and its real-time search and even Bing’s attempt to carve out shopping, travel, local, et cetera. My question is one, how do you think about the concept of vertical search? Two, how strong do you believe your offerings currently are, and particularly how well you are merchandising those offerings to consumers? And three, do you still see big monetization improvements as you think about vertical search and improvements in [inaudible]?

Eric E. Schmidt Ph.D.

Historically we’ve not used the term vertical search, because Google attempts to sort of answer the question without categorizing it as this category or that. Other people have said we are going to offer a special service around this or that. So we work very hard to sort of take the query without bias -- you know, this is the way it plays out.

So with respect to vertical search headroom, there’s plenty of such headroom, especially as our ads products get better. And so the reason we mentioned, for example, that in travel, it could come back but finance had not because that does in fact affect the revenue. We understand that but we try not to sort of say there’s a travel site or what have you. Longer term, you never know what kind of innovation we can do to do that. It’s been observed, for example, that in some of these verticals, the ads are particularly more valuable than even some of the search results but we’ve not yet thought through what we will do with that observation.

Jonathan J. Rosenberg

I think it is the case on the vertical side that there is a lot of opportunity to get incremental monetization gains where you can further qualify the leads better for the advertisers. So for example, the finance area and the travel area are areas where there’s a lot of opportunity to do that, so that you end up putting more information in the ad and then incrementally getting more information from the customer so that you can further qualify whether or not the customer in the finance area is interested in a particular type of mortgage, and then you send them to an advertiser with whom they are more likely to consummate a specific transaction that that advertiser is willing to pay for. So there’s a lot of opportunity there.

Christa Quarles - Thomas Weisel Partners

That’s helpful. Thank you.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Benjamin Schachter from Broadpoint Amtech.

Benjamin Schachter - Broadpoint Amtech

Years ago I recall Eric discussing the idea that advertisers should be thinking about the Google spend as COGS and not sales and marketing. I guess it was the notion that you give us a dollar, we’ll give you X dollars in sales. So now with more video images and structured data appearing in the stirrup, I’m just wondering -- should we expect to begin to see new monetization methods beyond just the traditional text based CPC actually appearing within the sort of basic Google.com [search]? Thanks.

Patrick Pichette

I’ll let Nikesh answer that.

Nikesh Arora

In fact, we are beginning to see other forms of advertising and monetization. You already have CPM based monetization on our video properties. We have CPC based monetization on our display networks. We have even CPA based monetization on a certain part of our display networks, so you are beginning to see different forms of monetization come forth in the online arena. And as we go forward, as more and more media begins to shift towards online, we are going to see different forms of monetization. Most recently, we are beginning to see more and more branded advertising on YouTube and on various display properties.

So yes, the trend is in that direction.

Patrick Pichette

Thank you. Let’s go to the next question, please.

Operator

And we’ll take our next question from James Mitchell from Goldman Sachs.

James Mitchell - Goldman Sachs

Thank you very much for taking the question. I wanted to dig a little bit into why the general and admin spending was so well controlled. If memory serves, you had some [inaudible] legal costs this quarter last year and some severance costs in the first quarter of 2009 but I wondered if there were any abnormalities in the second quarter of 2009, and also if there’s any reclassification from G&A to research and development.

Patrick Pichette

You are right that at the last quarter we talked about there were some kind of extraordinary items here and there that you will remember, legal settlements and restructuring sales and a few other items. But otherwise I think that what you see is the result of good, prudent focus on our general and admin and we are really happy with the trajectory and where we landed. But there’s nothing extraordinary, apart from what you just already mentioned.

James Mitchell - Goldman Sachs

Thank you.

Patrick Pichette

We’ll take the next question, please.

Operator

And we’ll take our next question from Sandeep Aggarwal from Collins Stewart.

Sandeep Aggarwal - Collins Stewart

Thanks for taking my question. Eric, can you give us some glimpses of how the world of computing will look like with the Chrome OS? And also maybe any comments on will it be a pre-installed deal with a PC OEM? Can it be downloaded? And if it can be downloaded, can it -- will it work with the existing installed base versus just a new PC shipment? Thank you.

Eric E. Schmidt Ph.D.

Thank you. What we talked about when we did the announcement a week ago was that we were going to build an open source version of Chrome OS and it will be available to the PC community a year from now. We are in fact talking to PC hardware manufacturers of both architectures, both ARM architecture as well as the Intel architecture, to design products that are very, very exciting that really fulfill the vision of cloud computing.

Other aspects of our strategy are still to be worked out based on the feedback and so forth. There will be a reference hardware spec, appropriate features, and so forth and our primary focus for that product will be speed and in particular, speed of boot, speed of computation, and the seamless use of all the web services that are the promise of cloud computing.

Will the software be generally available for download, will it run on existing hardware -- those are things to be worked out.

Because it’s open source, we won’t have the kind of restrictions that other people have and it will be very possible for people to take it and do almost anything that they want to it, which is another one of the great benefits of the Chrome OS.

Sandeep Aggarwal - Collins Stewart

Thank you very much.

Patrick Pichette

Thank you. Let’s go to the next question, please.

Operator

And we’ll take our next question from Youssef Squali from Jefferies & Company.

Youssef Squali - Jefferies & Company

Thank you very much. Two quick questions for Jonathan -- by some accounts, June was reported to have been maybe soft or softer than April and May for online advertising. Was that true for Google as well and was there anything outside of just seasonality to account for that?

And then YouTube, you talked a little bit about it earlier and you said that you were monetizing billions of videos per month. The last time I heard you guys talk about it, you were talking about hundreds of millions of videos. So are we comparing apples-to-apples and I guess lastly, what are the most popular ad formats right now?

Jonathan J. Rosenberg

Sure. Let me start with the first question. We generally don’t parse intra-quarterly trends, so I really can’t say anything with respect to how June was or wasn’t different. The only anomalous factor in this quarter I think was really the general timing of Easter versus in the previous year it was I believe it was in Q1 and this year it was in Q2, but I don’t really have anything else that I could offer.

I think what I said that was -- or what I meant to say was that monetizable views have tripled in the last year and that we are monetizing billions of views every month. Nikesh may be able to give you a sense from an advertiser perspective across the home page, the watch page, and the search pages, where we have different ad formats, featured videos, and the video promotion, promoted videos, which we are doing on the results pages, which he’s getting feedback from customers in terms of what they are the most interested in. I’ve certainly seen a lot of interest in the homepage mastheads which we’ve been introducing recently.

Nikesh, do you have any other feedback from the customers?

Nikesh Arora

No, I think, Jonathan, just to add to what you said, yes, we are beginning to see that YouTube has established in the advertiser space now that the YouTube homepage is of relevance and it is desirable for customers. So we are seeing significant sell-through in most of our major markets where we have YouTube homepage for sale.

In addition, we are beginning to see lots of interest in [inaudible] advertising, which is what customers want on the short clips that we are beginning to acquire from our major partners like Disney and the deal we did recently with Vivo.

So I think that next phase of YouTube is going to be towards pre-roll videos on short clips and long form video [which we are in the process of doing] various deals in, which we’ve announced in the past.

Youssef Squali - Jefferies & Company

That’s helpful. Thanks.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Doug Anmuth from Barclays Capital.

Doug Anmuth - Barclays Capital

Thanks for taking the question. Eric, you recently mentioned that display was the next billion dollar business and I think this is sort of a change, because I think you said search basically over the last couple of years. Is there anything in particular that has led you to sort of make this change beyond what you sort of talked about around YouTube here?

And how do you think you are benefiting at this point from the Double Click acquisition? And also curious about the Google Exchange rollout and how that fits into your strategy. Thanks.

Eric E. Schmidt Ph.D.

Nikesh has really been driving that area so Nikesh, why don’t you summarize where we are?

Nikesh Arora

I think the way to think about display for us is actually in multiple strands. One is clearly on the YouTube side, which you just talked about in terms of home page and pre-roll ads, which we are beginning to see some good trajectory in.

I think to couple that, the second area of focus for us is the Google content network, where we again see that the revenues are doing well and it’s performing well. There has been sort of an aversion to more performance-based display advertising in the last quarter because most of the advertisers had started going back to focusing on CPC and clicks.

Where we are bringing sort of the metrics of search to display effectively and we are seeing a shift away back from CPM to more CPC on the content network because display inventory continues to rise and people are beginning to want metrics to measure that.

On the third, as you asked about Double Click integration, we have made tremendous progress with the ad exchange. We have now integrated that, the Double Click has changed with ad words and ad sense, and we are seeing traction where publishers, advertisers, agencies all want to work with an exchange that allows us to expose inventory across the board, to sort of both parties in the transaction.

So I think Eric’s right that that is the next area where the online advertising is going to shift and we are going to see tremendous growth in the display space and we are excited about all three areas individually.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Spencer Wang from Credit Suisse.

Spencer Wang - Credit Suisse

Good afternoon. Just two quick questions -- I was wondering if you guys could talk a little bit about the new trademark policy and if -- and what the results have been since you rolled that out since mid-June.

And then just a follow-up again on the YouTube question -- when you guys talk about YouTube being on a better trajectory now, is it just a function of increasing the number of monetized views, or can you talk a little bit about maybe some of the click-through rates on the ad formats and what you are seeing now versus previously? Thank you.

Jonathan J. Rosenberg

I’ll handle the specific question on the trademark change first. I believe we implemented that around the middle of June and basically it’s just an update to the trademark policy in the U.S. for Google.com, AFS and AFC, so that advertisers can use trademark terms in their ad creative if they are resellers or an information site for the product with the trademark, and generally we are seeing significant interest in that. I don’t have any specific revenue numbers to offer you but you can certainly try some ads yourself and get a sense of how frequently it is being used.

On the YouTube side, Nikesh, do you have some comments?

Nikesh Arora

The YouTube trajectory has effectively been about our ability to scale, so we’ve introduced ad formats. We’ve gotten into the selling process, the selling cycle with agencies and advertisers and we’ve been able to go out and sort of train our sales force to go and make these sell-throughs happen. So the reason we are excited about it is because now we finally got all the pieces in place, the agencies that are getting into the selling process and the buying process and getting our teams ready.

Secondly on YouTube, we are also now getting excited about the pre-roll stuff because we are beginning to bring more content. The promoted videos idea, where we can promote partner content up-front so we can shift more and more user views towards more premium content allows us to create more inventory -- couple that with the fact that our teams are now out there selling advertising as pre-roll to various advertisers, that creates the scale and the breadth that we need to go and drive this forward.

Spencer Wang - Credit Suisse

And Nikesh, what’s the impact on the user experience on pre-rolls?

Nikesh Arora

The pre-rolls have -- if you look on the web, if you look at premium content, users are accepting that when they are going to watch premium content, they are going to have to see it supported either by some form of advertising funding or perhaps they are going to have to pay for it at some point in time. So it is becoming accepted user behavior that if they are going to watch premium content where people have invested money in creating it, they are going to watch pre-roll.

So I think there seems to be a general acceptance around this area.

Jonathan J. Rosenberg

We do look carefully at the drop-off rates with the pre-roll, and there’s very little drop-off, so we are generally pretty optimistic there.

Spencer Wang - Credit Suisse

Thank you.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Jeffrey Lindsay from Sanford Bernstein.

Jeffrey Lindsay - Sanford Bernstein

Thank you. Could I ask, given the changes in YouTube, the increase in [inaudible], is YouTube actually profitable on a contribution basis or is it a net negative? And then secondly, do you intend to make any money from the operating system? Will you for example charge for it or will it be given free as part of Google Apps? How will that work? Thank you.

Patrick Pichette

So on the first one, we don’t give the economics of YouTube. What I can tell you is that we are really pleased with the trajectory of YouTube. We are really pleased both in terms of its revenue growth, which is really material to YouTube and in the not long, too long distance future, we actually see a very profitable and good business for us, so from that perspective, we are really pleased with the trajectory.

And on the second one, I’ll let Eric answer.

Eric E. Schmidt Ph.D.

On the Chrome OS, because it’s open source, we do not plan to charge for it in an open source form. There may be other ways in which we make money from it but the core operating system, if again you go and read the blog post, you will see we said this is an open source project which will be available for anyone to use.

Jeffrey Lindsay - Sanford Bernstein

So that means that even though you will incur the cost of doing the development, there’s no opportunity for you to make any money with it?

Eric E. Schmidt Ph.D.

Well, first remember we do this with a lot of products. For example, our Android product, there are many other pieces of technology that Google builds and the rough argument is that we do things that are strategic because they get people to ultimately use the Internet in a clever and new way more, and we know that as they use the Internet more, they ultimately search more or watch more on YouTube and we then know that our advertising works in a particularly strong and targeted way.

So we do not require each and every project to be completely profitable or not profitable. We look at them in a strategic context -- are they making the web a better place? And by making the web a better place by getting more and more people on line, especially on broadband connections, we have a lot of data that says that ultimately results in very, very strong revenue growth from us because of the targeted ads that we offer.

Jeffrey Lindsay - Sanford Bernstein

Thank you.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Jeetil Patel from Deutsche Bank.

Jeetil Patel - Deutsche Bank

Thank you. A couple of questions -- I guess when you look at OEM licensing fees and if that makes sense or not, but just broadly, what is your view on consumer paid services, if that makes sense in terms of leveraging your audience and the myriad of services that you offer today to go after somewhat of a consumer pay model, whether it be your own products or other products, say ISVs participating in Chrome OS over time?

And then second, a question around budgets of late -- as you talk to marketers and advertisers, are you hearing that they are perhaps holding back budgets until the seasonal strength of August, September, and onward, which is typical of the seasonal trend that we’ve seen in the past?

Eric E. Schmidt Ph.D.

On the first part of the question, if our platform strategy works and if there are many users of the Chrome OS, there will be many opportunities to build profitable services on top of that platform. That’s been true for all of the successful platform plays over the history of computing and they are likely to be large if it’s successful. If it’s not successful, then it doesn’t really matter. So our focus right now is on building a truly new experience, something very different from the existing operating systems and then see how broadly that can touch people’s lives on a day to day basis in the new model of cloud computing.

As another general statement, it is certainly my belief that you will see a duality between advertising and subscription services and that eventually monetization and the web will have a very successful advertising model, which of course Google is the leader or one of the leaders in, and also a fair number of strong and successful subscription services, which include micro payments and so forth and so on. And that infrastructure has yet to be built, in my view, broadly. But it makes sense that ultimately content will be either advertising supported or charged for and that content here includes content in the form of movies and videos and so forth, but also things like software and so forth and so on.

So with that, that answers the first half of the question.

Jonathan J. Rosenberg

I think the second half was just about advertiser budgets. I guess Nikesh can maybe give you a perspective from what he’s actually hearing from the advertisers. The one thing I would like to remind you there though is most of our advertisers are not maxing out their daily budgets, so they will always take more clicks if we can give them to them. So in many ways, if that’s not the right question to ask, but if Nikesh has specific views of what he is hearing from the advertiser community, that might be helpful.

Nikesh Arora

I think, Jonathan, you are right. Effectively, what we’ve been spending our time with the advertisers is convincing them that search is an ROI based media and we can’t create inventory. Inventory depends on consumer behavior.

So they have worked with us to open their budgets and put out there. What they said is they set very rigorous ROI benchmarks on their bidding so we understand that they will buy a click at a certain price, but they keep their budgets open with us for the most part, which allows them to buy as much inventory as is created on that particular day.

Jeetil Patel - Deutsche Bank

A quick follow-up on that ads versus subscriptions -- do you think that there’s a business model from kind of a royalty standpoint as ISVs build out apps on top of Google Chrome OS?

Eric E. Schmidt Ph.D.

Again, too specific a question -- we don’t know yet. It makes perfect sense that there will be new forms of ad application and distribution. Exactly how they get monetized, there are probably multiple ways. There are people who are experimenting with ads inside of applications. There’s obviously the subscription model, which others are trying and we’ll know. But the good news is we can talk about this for a long time because we won’t really know for a year or two.

Jeetil Patel - Deutsche Bank

Looking forward to hearing about it more.

Patrick Pichette

We’ll go to the next question, please.

Operator

And we’ll take our next question from Heath Terry from FBR Capital.

Heath Terry - FBR Capital

Great, thanks. Not to over-ask the YouTube question but you mentioned that YouTube monetized views have tripled year over year -- can you give us a sense of what portion that is currently? And can you talk about the challenges to monetizing the non-partner inventory that make up the rest of those views?

Jonathan J. Rosenberg

I guess I don’t understand the question with respect to a percentage.

Heath Terry - FBR Capital

Well, you mentioned that YouTube had -- monetized views had tripled year over year, so I mean, I am assuming there’s a portion of those that are non-monetized. I was just curious if you could give us a sense as to maybe not exact percentages but what that portion looks like.

Eric E. Schmidt Ph.D.

In general we don’t -- we haven’t sort of dissected all of the numbers within YouTube. The majority of YouTube views are not professional content. They are user generated content because that’s the majority of what people are watching. It’s also the majority of what is submitted. YouTube is accepting more than 15 hours of video every minute here and that’s only increasing, which gives you a testament of the power of YouTube.

Heath Terry - FBR Capital

And in terms of being able to monetize the non-professional side of that inventory?

Eric E. Schmidt Ph.D.

Has not been our focus. It’s probably possible to do so but the fact of the matter is that the majority of the non-professional content has relatively small number of viewers. It’s difficult to target it accurately. There’s too much variation and so forth, whereas the professional here and remember, professional here just doesn’t mean big studios. It also means smaller studios, new entrant start-ups who are professional quality. And you can tell a professional quality video from a user generated one. It’s easy enough. And you can tell the difference between the two.

Heath Terry - FBR Capital

Okay, great. Thanks.

Patrick Pichette

We’ll go to the next question, please. We probably have time for one or two more questions.

Operator

And we’ll take our next question from Steve Weinstein from Pacific Crest.

Steve Weinstein - Pacific Crest

Thank you. It looks like over the last few quarters the TAC as a percentage to the network partners has been declining, and I understand that there’s all sorts of mix issues and seasonal issues that go into that but I am wondering, given the momentum that you are seeing with Ad Sense for content and display ads, if we kind of spread that trend out, if we can continue to see a downward TAC being paid out as a percent of the network?

Patrick Pichette

I’ll answer that. There’s a lot of mix issues with TAC, so first of all, when you look at it relative to last year, there isn’t these massive swings in TAC. There’s clearly mix issues, so on the ad sense and partner networks, obviously you know if you have a mix with more of your smaller partners than your larger partners, it will influence the mix that way. Clearly with Google TAC, it’s not a big change but it reflects the fact that we have more partner deals to bring people to Chrome, to bring people to toolbar.

So there’s no really big tectonic shift in any way, shape, or form but what you see is just the effect of these mix on kind of a quarter to quarter basis just at work.

Steve Weinstein - Pacific Crest

Okay. Thank you.

Patrick Pichette

Thank you. We’ll take one more question, please.

Operator

And we’ll take our final question from Jim Friedland from Cowen & Company.

Jim Friedland - Cowen & Company

Thanks. A question on Google apps on the enterprise edition -- two parts to it. First you charged $50 per user per year. Over time is you view not only to ad services and continue to charge that level but could you also offer premium features so that you generate more revenues per customer?

And second, as you talk to enterprises, what are the key barriers to adoption that you are hearing? Thanks.

Eric E. Schmidt Ph.D.

At the moment, of course, we are very happy with the $50 a year model. We obviously have the opportunity to put in additional value-added services over time. We’ve got our hands full just sort of pursuing the current opportunity. I think over time you can expect we would broaden to some of those ideas on a per product basis.

When you look at the barriers to entry in that market, they are actually pretty easy to understand. The customer has a large and existing investment in infrastructure, which is relatively highly specialized. It takes them some time to convert or adapt the systems that they have to use the new web-based computing. This of course is the fundamental narrative of these product transitions and that’s why they take so many years to go through. It’s not that the customers don’t want to make the transition. The issue is that there’s some feature or some unique thing that they depend on.

Examples would be in the category of security services. Often the security systems are relatively highly specialized. Access to specific and often historically significant but currently not very significant database systems that they still need to have access to. Other kinds of things which are just tactical -- in other words, they just require some amount of work and over time, we will knock down some of those issues, some of those would be conversions that people will do, et cetera, et cetera.

We focused, for example, on the most common ones -- Outlook, we’ve now launched an Outlook synch product. The use of Blackberries and particularly the BlackBerry enterprise server. We now have very good BlackBerry support as part of our apps. So those are two of the ones that we’ve been able to knock down in the last few months that have been very high priority, but there’s certainly more.

Jim Friedland - Cowen & Company

Great. Thank you.

Patrick Pichette

Thank you. With this, we will close the call. Let me thank everybody for taking the time to listen to our call today. Just to summarize, we are very pleased, we had a very good quarter in what is a stabilizing but a difficult economic environment. I also would like to thank Googlers for their incredible contribution in Q2. What a great progress. And thank you for listening.

So Jonathan and I will be able to talk to you for the people that go for the second call in about half-an-hour’s time. Thanks again and with that, I’ll let the Operator close the call.

Operator

Thank you. That does conclude today’s conference. We thank you for your participation.

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Source: Google Q2 2009 Earnings Call Transcript
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