Google (GOOG) reported earnings for Q2 on July 18. The company’s stock declined by 4% after market as the results disappointed investors. The company reported consolidated revenues of $14.11 billion, up approximately 19% year-over-year. Google’s core revenues (revenues ex-Motorola) grew to $13.11 billion, growth of 20% year-over-year. While the company reported strong top-line figures, its operating income fell by approximately 4% to $3.12 billion.
In our pre-earnings article, we had argued that cost-per-click for Google will decline in the quarter as advertisers are increasingly routing their budget spend towards mobile devices [See Google Earnings Preview: Mobile Is Key To Revenue Growth]. Mobile advertising continues to drive traffic and reduce the cost-per-click [CPC], which declined by 6% in Q2. However, aggregate paid clicks posted solid growth increasing 23% y-o-y and 4% quarter-over-quarter. This led to a 20% y-o-y increase in advertising revenues on Google properties.
Cost per Click Falls as Mobile Traffic Increases
Mobile was again the focus during the company’s earnings call since it will be the key to Google’s business going forward. We currently estimate that mobile search ads contribute approximately 32% to the firm’s value. Gartner has predicted that worldwide mobile ad revenue will exceed $11 billion in 2013, and that the growth rate for ad revenue will exceed 400% during 2011-2016 [Gartner Worldwide Mobile Advertising Revenue, January 17 2013, www.gartner.com]. Even though mobile search ads are expected to only generate 17% of the company’s total revenues in 2013, we expect the proportion to increase to 35% by 2019.
Traditionally, cost per click CPC for mobile ads is lower compared to that of a PC. As traffic from mobile devices increased, average CPC for Google declined by 6% in Q2 2013. (Statistics on mobile usage and adoption to inform your mobile marketing strategy, June 10 2013, www.smartinsights.com) Since the average revenue per search is lower for mobile ads, the growth in mobile advertising will continue to weigh on average cost-per-click charged to advertisers in the coming quarters.
However, to eliminate the difference between PC CPC and mobile CPC, Google has recently launched its new AdWords program, called enhanced campaigns. This new program automatically bundles desktop, tablet and cellphone ads for all campaigns and will be mandatory for all advertisers from Monday, July 22nd. Advertisers can choose not to buy cellphone ads but are required to buy tablet ads. According to Google, this program simplifies the process for advertisers and makes it easier to reach customers who use multiple devices with different screen sizes. If this program is successful, this should limit the decline in CPC. Additionally, we think that the Android platform will continue to lead as the preferred mobile device platform, and this will increase the number of aggregate paid clicks which can offset the decline in CPC to some extent going forward.
Motorola Continues To Dent Operating Income
In our pre-earnings article we mentioned that we would be closely watching the Motorola division because it continues to post operational loss since its acquisition last year. Motorola posted another quarter of disappointing results. While the GAAP revenues for this division grew by 18% y-o-y to $998 million, the GAAP operating loss for the division increased to $342 million. As a result, consolidated GAAP operating income for Google declined by 4% y-o-y to $3.12 billion.
With the inclusion of the Motorola division on Google’s financials, hardware has become a significant portion of the firm’s revenues. While we believe that this division will continue to be a drag on Google’s margins, we think that synergies between Android and Motorola’s smartphone/tablet business will make the Google – Motorola combination an interesting player to watch in the hardware industry. Motorola is looking to launch itself back into the mainstream mobile market with the launch of Moto X smartphone in the coming month and we continue to closely observe this event.
Growth In R&D Spend
As Google continues to innovate, its R&D spend is on the rise. Its R&D spend as a percentage of revenue grew to 14% in Q2 2013 from 13% in Q2 2012. During Google’s earnings call, CEO Larry Page continued to stress on developing new products and backing highly speculative projects, such as Google loon, in search of new revenue streams. We expect EBITDA margins to suffer as Google continues its search for the ‘next big thing’.
We currently are in the process of updating our Google model. At present we currently have a $802 price estimate for Google, which is approximately 10% below the current market price.