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 call over to Maria Shim, Director of Investor Relations.
Good afternoon, everyone, and welcome to today's third quarter 2009 conference call.
With us are: Eric Schmidt, Chief Executive Officer; Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President of Product Management; and Nikesh Arora - President, Global Sales Operations and Business Development.
Today we are trying a new process on our earnings call. Eric, Patrick, Jonathan, and Nikesh will each provide us with their thoughts on the quarter and then we will take Q&A from Google Moderator. This is our first time using Google Moderator to respond to questions from the investment community, so let be briefly explain the process.
Please submit your questions via the Moderator page that we have sent out and the audience will vote on the most relevant questions. We will only be taking questions that are relevant to today's earnings results and Google's long-term strategy.
I will read the question and the name of the person who submitted the question and then have Eric, Patrick, Jonathan, or Nikesh answer.
This call is being Web cast from our Investor Relations Web site located at Investor.Google.com. Please refer to our Web site 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 Web site in a few hours.
Please note that we routinely post important information on our Investor Relations W Web site located at Investor.Google.com and we encourage you to make use of that resource.
As a reminder, we're 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 pm Pacific Time and will also be Web cast from our Investor Relations Web site.
Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking, including statements regarding investments in our long-term growth and innovation, expected performance of our business and our expected levels of capital expenditures. These statements involve 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 description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our Web site.
Also, please note that certain financial measures we use on this 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 Eric.
Good afternoon to all of you and welcome to our third quarter earnings call.
Let's start by summarizing where we are. You know, while there is obviously a lot of uncertainty about the pace of economic recovery, we believe the worst of the recession is behind us and we're seeing lots of signs of that in all of the industries that we pay attention to. So we're very optimistic now about the future. We now have the business confidence to invest heavily in the next phase of innovation, hoping to invent the future as we see it.
Our performance in the quarter was a strong quarter. 7% year-over-year revenue growth. We performed well across all of the financial metrics of the Monitor, so it's all good news from our perspective, at least in looking at the quarter. And we're going to continue to invest in long-term growth. We tested our management team and I want to say that I'm very, very proud of the management team getting us through what could have been a very significant position for Google and we've proven the worth of this team.
Tight control over costs, combined with continued innovation in search and ads, Chrome and Android, mobile, these huge opportunities ahead of us, the resources and expertise to invest heavily in long-term growth for the benefit of users, customers, and shareholders.
So how are we investing? Well, we're going to invest in people. We're already stepping up our hiring. And also in innovation consistent with our 70-20-10 principles. The technological precondition for growth, if you will, is this investment in innovation.
In the 70%, everybody here on the call I think knows, that that's our core business. We want to really get to the perfect search engine. We made about 120 search quality improvements in the third quarter with more, of course, coming this quarter and then we hope every quarter.
And we're working to create much better ads. It's important to remember that many of our advertisers would like to find more ways to spend money with Google if our products would allow them to do that. And we want to make that possible and really serve their needs.
And that 20% out of the 70-20-10, we're stepping up our investment in up-and-coming businesses. Mobile, a high-growth business for us already. 30% quarter-over-quarter growth in mobile searches in the third quarter.
Android, as you know, has come a long way in a year, from one device with one carrier in one country and now 12 devices in 26 countries with 32 carriers with much more coming.
In the display and YouTube area, both which, of course, are doing well, we have a great base. We have a million publishers choosing to use the AdSense product. And of course many, many AdWords advertisers. And we've now added Double Click to the mix, integrated with Google with our exchange and all of the things Double Click can now offer. So you have a great business, it should scale pretty rapidly.
And again, even with our enterprise business, which we've been working hard on for some time, not only is our business accelerating, but I actually personally spoke to a number of our customers, for example, Motorola, Genentech, and Johnson Diversity, getting feedback very strong. They need more of this product and they need us to address product shortcomings, and I think the products will do very, very well.
In the 10%, promising areas where we think there is a real opportunity to innovate, Google inspired development by basically pushing our breadth of hiring, partnerships with wireless and developers, but also we're going to focus more on strategic deals and acquisitions, as we have discussed publicly. And we're open for business in making strategic acquisitions, both large and small.
So to put it together and I think it over to Patrick for his analysis of his financials, I will tell you that we are very, very happy with Q3. The worst of the recession clearly behind us and because of what we have seen we now have the confidence to be optimistic about our future and we're going to invest as a result, and that I think is ultimately good for the long term of Google.
So I will go through the results quickly and then I will turn it over to Nikesh and Jonathan for a bit more detail on our performance.
As Eric said, at a high level, we are very pleased with our Q3 results. Gross revenue grew 7% year-over-year to $5.9 billion and our business was strong across the board. At Google.com, for example, the revenue was up 8% year-over-year to $4.0 billion, contributing a significant portion of our year-over-year growth. The traffic growth continues to be healthy, and we saw stabilization or improvement in most of our major markets.
It is actually worth noting that Q3 also benefitted from a number of Ads Quality launches.
In AdSense we saw an increase, up year-over-year 7% to $1.8 billion, driven primarily by growth in our AdSense for content and our display initiatives. Our global aggregate growth remained very healthy, up 14% year-over-year and 4% quarter-over-quarter.
Our aggregate cost per-click growth was down 6% year-over-year but up 5% quarter-over-quarter with FX playing quite a factor in both the year-over-year and quarter-over-quarter comparisons. So FX had a negative impact on the year-over-year for CPC growth but a positive one quarter-over-quarter due to the weakening of the U.S. dollar during the quarter. Remember, too, that this is an aggregate number, which includes diverse geographic markets, some of which may have lower CPCs and also includes both Google and AdSense properties.
Turning to our geographic performance, revenue from the U.S. was up 4% year-over-year to $2.8 billion. International revenue accounted for 53% of our total revenue, or $3.1 billion, with $39.0 million benefits of hedging programs for this quarter.
The U.K. was down 1% year-over-year to $765.0 million, negatively impacted by FX as well as an ongoing macroeconomic weakness, but this was partially offset by revenues from our hedging program.
It is worth noting that using a fixed year-over-year exchange rate, our total revenue would have been roughly $300.0 million higher.
Let me now turn to expenses. Traffic acquisition costs were $1.6 billion, or 27% of total advertising revenue. Our other cost of revenue was $667.0 million. And finally, all other operating expenses totaled $1.6 billion, including approximately $303.0 million for our stock based compensation.
On a year-over-year basis, our opex, excluding SBC and other cost of sales, was lower by $14.0 million and up $81.0 million quarter-over-quarter. The increase quarter-over-quarter was primarily due to increases in payroll, equipment, and facilities-related expenses.
So as a result of all this, our non-GAAP operating profit, which excludes stock based compensation, increased to $2.4 billion in Q3, resulting in a non-GAAP operating margin of 40.2%.
Headcount was slightly down, ending the quarter with approximately 20,000 full-time employees.
So as Eric said, we believe the worst of the recession is behind us and we feel confident in investing in our innovation agenda in a targeted and disciplines way, and that includes accelerating hiring across the organization, particularly in engineering and sales.
Let me now turn to cash management. In other income and expense we had a net expense of $7.0 million for Q3. For more details on this, please refer to the slide that are accompanying this call on our Investor Relations Web site.
Our effective tax rate for the quarter was 21% and let me remind you that any changes to the mix of earnings between domestic and international subsidiaries, as well as the effect on our earnings from various hedging activities and the related items, obviously have an effect on our tax rate.
So let's complete the report right now. Operating cash flow very strong at $2.7 billion. Capex for the quarter was $186.0 million, again, primarily related to our data center operations and we will continue to make significant capex investments, although they're lumpy. Free cash flow, very strong at $2.5 billion.
So in summary, very pleased with a strong quarter in Q3, across revenue, margins, and cash flow. We are managing the company to best position ourselves for long-term growth and accelerating our pace of innovation. We're disciplined but fully investing in big, long-term opportunities, whether it be in search, display, mobile, or apps.
With that, I will turn it over to Nikesh to cover with more color commentary.
I just wanted to spend a few minutes going over our performance across our businesses and our markets. Firstly, our core business continues to drive our growth. If you look at our performance across our four global regions, in the Americas the U.S. trend was across the board, but especially amongst our larger advertisers as they have come back into the market in the third quarter. We've had a major push in the U.S. to further streamline our sales processes and go out and meet most of our large advertising CMOs.
In addition to the large advertisers, Brazil was a good performer and a good stand-out in Latin America with strong revenue growth.
If you look at our region which covers Northern and Central Europe, we have begun to see stabilization across the board as economies started to emerge from the downturn. The U.K. has showed strength for us in the last quarter.
Our third region that includes Southern and Eastern Europe, Middle East and Africa, we also saw solid performance from that region. Particularly Spain has shown strong signs of revival, fueled by the travel of retail and automotive verticals.
Our fourth region, Asia Pacific and Japan, we continue to build and strengthen our teams. China was a strong performer as an emerging market and Japan has seen some benefits from reorg of the sales team, the mobile growth, and a more favorable economic climate.
If you look at our partnerships over the last quarter, we have had a strong level of AdSense renewals and new agreements which include British Telecom, Discovery, Distro, and e-Bay, with whom we have signed a global deal. This deal with e-Bay renews our long-standing partnership with them on their non-U.S. properties as well as their classified and shopping sites. In addition, it also extends the partnership for the first time to e-Bay.com.
Now if you turn over to our display business, as Eric mentioned earlier, we made a lot of progress across all three parts of our display business, which have strong results. Firstly, in our owner-operated properties, we are pleased with our progress. On YouTube we have added new partners and advertisers and further improved monetization. Today we can say that 90% of the top 50 adage advertisers have run campaigns with successful results on YouTube. Hewlett Packard used YouTube home page, promoted videos, [inaudible] as well as content network and search for its back-to-school campaign. It has at over 2.7 million channels users in 170 countries with over 6,600 subscribers and 4,000 submissions. Recently Palm used the YouTube home page and its YouTube channel as well as the common network in a recent campaign. And McDonald's also ran a YouTube video ad on the home page to promote its McCafe product.
On the partnership side of YouTube we signed some important partnerships with Time Warner and Warner Music during our third quarter. We now have deals with four major record labels and publishers, along with many independent labels, bringing more premium content to the site. This morning we announced that we had partnered with Channel 4 in the U.K. to bring full content TV to YouTube.
Generally, we are developing successful expertise and selling home pages, and now we are in the process of relieving free-hold inventory which is an area we expect to further drive monetization.
If you look at the second part of our display business, which is our content network, we continue the show of healthy growth. We continue to focus on publisher acquisition and improving the monetization of our network. Specifically, we are attracting key advertisers for both direct response and branding campaigns. As Eric mentioned, we have now over 1.0 million publishers in our AdSense network.
The third part of our display business, which is beyond our network, we are very excited to announce the new Double Click ad exchange this quarter. The ad exchange is a key part of how we can open a display ecosystem. It's introduction is already being received very positively by both ad networks and publishers with contractual commitments from major partners and migrations from the original Double Click ad exchange, already near completed in several countries. Over half of the largest 25 ad networks in the U.S. are already using the new ad exchange.
It also provides substantial benefits by giving our AdWords advertisers access to more high-quality inventory enabling third parties to advertise on our AdSense publishers' sites.
In our enterprise business we continue to push forward. We have had some big customers wins in the last quarter, including Rentokil which has 35,000 users, [inaudible] cycles 17,000 users, and Clinica with 7,000 users. We are also seeing lots of traction among small and medium-sized businesses, which continue to increase at a fast pace.
Lastly, on a personal note, I want to say I am very pleased with the performance of our sales team this quarter, because this quarter we have transitioned many of our senior leaders but the team has maintained its focus on going out there and driving sales and we continue to invest in our emerging business in emerging markets and we hope to continue to do that in line with Patrick's and Eric's comments.
With that, I'm going to hand it over to Jonathan for product insights for the quarter.
So Eric mentioned that we're investing in long-term growth, and you will remember, of course, that we said we would take the long-term focus in our founder's letter, and I think recently we've really been pushing a number of investments and big bets that are consistent with that long-run principle. So what I want to try to do is just quickly walk you through a few of those examples.
One of the biggest 2009 investments is the new AdWords Front End and we transitioned pretty much all of our advertisers to the new user interface this quarter. And it was really the biggest overhaul to AdWords which we've ever done and the advertisers now have lots of new reports, they're running much, much more efficient campaigns and we have a new infrastructure that will make it much easier for us to roll out new features moving forward.
We are also making a big investment push in developing new ad formats and we are beta testing a new ad offering which we call local listing ads. And with that you basically sign up with just a simple one-page form. You don't have to deal with key words, you don't have to deal with bids to manage. There's a simple flat monthly rate. And if you don't have a Web page, the ad can link to your place page, and that's a free page that we generate and you can edit. It has all sorts of information about your business. And we've launched about 50.0 million of these place pages. And the phone numbers on the ads go through Google Voice so you can actually track the calls you get and you know which ones were generated by your Google ad. The call actually comes in and it literally says, "This call brought to you by Google." And the trial is right now just in San Francisco and San Diego, but if you enter "coffee, San Francisco" you can actually see one of the ads.
Last week we also launched a new maps data set and we're now using that in the U.S. and Mexico. This was a huge investment but it's going to give us a lot more flexibility to create new types of maps. If you think about it, if you're a tourist you probably want a different kind of a map than if you're a local. And now we're going to be able to have the base to build in features like that.
I also sometimes hear that it's not always obvious how some of our big product investments tie together. If you look here at what we're doing with maps and local, you will see that we have the ads infrastructure, geographical data, Google Voice, and place pages and those things are now all working together to create a very compelling solution for small local businesses. So everything is now really finally in place for local businesses to easily connect with customers online.
And we're also investing a lot in user experience and the whole underlying infrastructure that's needed to support it. We see users today come to us with much, much harder queries than they used to so we're adding more ways for them to work with the results and to get what they need.
We launched a bunch of new features in search options. That's the little "show options" toggle switch which you'll see it in the blue bar above your search result. And now you can opt to just look at the results from, say, the past hour or whatever time period that you want. So if you're researching an upcoming purchase, like you want to buy a camera or something, we have a "fewer shopping sights feature" and you can filter out many of the commercial sites if you just want to look at more reviews, but then later you can opt to see more shopping sites, which shows you the more commercial sites, along with their prices.
Eric and Nikesh mentioned the display business. That's going very well but we think it's still a highly inefficient industry. Something like 25% of all the publishers' ad space still goes unsold. So we've launched a new Double Click ad exchange and this was a big investment and project and a key milestone in the culmination of the Double Click acquisition. Our goal there is basically to increase the size of the pipe for everyone, advertisers, agencies, ad networks, and publishers.
And finally, we're placing some big, big bets on making the Web better. We shipped the new release of Chrome that's more than double the speed of our first launch a year ago and we also launched Chrome Frame, which is an open-source plug in for IE that dramatically speeds up Java script that invoke it. So speed matters and we're going to keep investing in big projects that make the Web faster.
So you're probably getting restless by now so I'll take it back to the questions.
So we will turn it over to Maria and the operator to go through the questions that we have online.
We'll take the first question from Mark May – Needham & Company.
Mark May – Needham & Company
What are your goals with the recently relaunched Double Click ad exchange and do you think this offering could be a material contributor to Google's overall business revenue over the next one to three years?
I can start and maybe Nikesh can help me. We think, as I mentioned in my prepared remarks, that we are making great progress with fixing the whole fractured and very complex ad ecosystem. What we still need to do is we've got to make it much easier for the advertisers to run their display campaigns across a much broader range of Web sites. We have got to create demand for the publishers ad inventory, much of which I mentioned on the call goes unsold. We have got to open up this whole ecosystem and really the goal is to grow the pie for all the players.
So as we get better tools for the publishers to improve the forecasting and extract the value of the available inventory that they have, and as we make it easier for the advertisers to plan and better target their desired audiences, we think we will make significant progress.
Maybe I'll let Nikesh talk about the customer responses and the revenue opportunities.
I think you said most of what we wanted to say, but as I mentioned, over half of the largest 25 ad networks in the U.S. are already using the new ad exchange, which is a good thing. In addition to which we are seeing a lot of interest from other networks in the market so I think the ad exchange is an important element of the display ecosystem and exchanges are going to be relevant going forward.
The next question comes from Imran Khan - JP Morgan.
Imran Khan - JP Morgan
Can you please help us understand what drove 6% decline in Cost-Per-Click? I am trying to better understand the impact of FX versus mix shift versus the impact of the economy.
So we don't provide all of the details but it's very clear that the FX had an impact on these numbers. There are two things that we have to take into consideration. Take a step back, paid clicks continued to be quite healthy with 14% and 4%, both year-over-year and quarter-over-quarter, so we're very pleased about that.
On the CPC growth, if you go back year-over-year, so relative to Q3 2008, the Euro actually had an 8% difference, the pound a 15% difference, and the Canadian dollar, to take another one, also closed at 8% difference. These numbers are material. They will drive quite a bit of impact in the financials. So if you reverse engineer all these numbers, that will give you a good sense of it.
Second is, don't forget that we have quite a good healthy growth in international markets, which are, in many cases, lower CPC but they add dollars. So we're not worried about lower CPCs and when you get dollars and more performance. So this would be at the highest level.
Jonathan, any additional comments on the issue?
No, I think Patrick nailed the primary issue in FX. I think the second issue—we've talked about this on previous calls—it's that more of the clicks are coming from countries with lower CPCs. So we always want to caution you about not reading aggregate CPC metrics as a direct reflection of price changes.
We received two questions on acquisitions from Brian Pitz – UBS and Jeffrey Lindsay - Sanford C. Bernstein.
Brian Pitz – UBS
Jeffrey Lindsay – Sanford C. Bernstein.
As to Eric's comments on Google looking to acquire again, whether there was some sense of strategic holes in the business and if we are going to be doing a large, transformative acquisition or will our policy still be to make small technology oriented type acquisitions.
The way we think about acquisitions is we have historically done an acquisition, perhaps one a month or so. And those are typically small and they are typically complete an offering, they are typically technology intensive, they're not very expensive in the scheme of things and they bring some specific technology.
So in search there are a number of companies that we've looked at. Again, small companies that have invented some very interesting way of doing, for example, a kind of vertical search or a kind of analysis of how search should perform.
In the area of advertising we've looked at, for example, in the display category there a number of small companies that have figured out better ways of sorting and working on display ads.
As we build out our enterprise business, there are obviously small companies that, again, have pieces of the offering. In the area of, for example Chrome and Chrome OS, there are parts of that platform that are most efficiently built by adding features that are already being done by small companies.
Obviously in Android similarly and so forth.
So there is no particular rhyme or reason or prioritization aside from the 70-20-10, that I already talked about. It's very much a function of the specific individuals.
We are certainly looking for larger businesses to buy but in those cases it would have to be some significant strategic rational. Some accelerant that it would provide for revenue, some major, major user base that we did not currently have access to. And so they are going to be quite infrequent.
So if you think about it, our two largest have been Double Click and YouTube, both of which look as though they are going to be incredibly successful, but the integration costs, the acquisition cost itself, was quite significant.
So those would be relatively rate and if I were to estimate the frequency, it's hard to say. But it's certainly not monthly. Maybe every year or two. But certainly not every month.
The next question comes from James Mitchell - Goldman Sachs.
James Mitchell - Goldman Sachs
Have recent Gmail outages resulted from rapid user growth, under-investment in server capacity, or other factors?
It's a little unclear what outage you are referring to. There was a high-profile outage I believe on September 1 to the Web interface and it lasted about 100 minutes. And clearly that's a very big deal to us. We understand how much users depend on Gmail and we certainly learned a lot from it and we have taken steps to make sure that it doesn't happen again.
We are also very focused on improving recovery time if an outage does occur. That information is posted on the blog and I think the blog response that we posted actually covers in detail what happened. Generally it related to under-estimating the head room, from a machine perspective, during some routine maintenance that we did that led to a cascading failure. But it wasn't a function of under-investment in server capacity or anything like that.
The next question is on capex from Christa Quarles - Thomas Weisel Partners.
Christa Quarles - Thomas Weisel Partners
Capex is down 70% year-to-date. Help us understand what was going on before and what is going on now. Previously were you overspending during the search cold war? Are you under-spending now?
I will take this question and I'll make it a reference to the previous question. Let me make an overall note that you will remember in the previous quarter I had warned everybody that if you just kind of take a ruler and go down, we would hit kind of zero capex sometime in mid-September. And obviously that has not happened. We're investing. And we're investing heavily. It just happens that capex is lumpy.
In referring back to the Gmail, we have all the capacity we need for all of the infrastructure. We pre-fund. We have capacity ahead of what we think our needs are going to be. We have been very fortunate in the last few quarters.
A combination of very performance assets and really good utilization, as well as in a few cases, like I've talked about Scandinavia, a few delays created these timing issues, but clearly we are focused on investment.
Maybe Eric, you can turn it back—we talked about investment at the front end of the call—and make the bridge with it.
I would like us to be spending more in this area because I think that the opportunity that it creates, that capital spending creates a very significant platform for future products, future growth. Part of the reason that you've seen over the last year or two, a decrease in capital has been we've been able to do some very, very significant efficiency improvements that are basically software.
The hardware that we had deployed was not as highly utilized, technically not as busy. So we were able to increase that. And that goes right to the bottom-line in terms of capital spending. And that was a big project in engineering.
We've also benefited from the Moore's Law-related efficiency improvements with the multi-core architectures. And what's happening, of course, is that the chips are now going four-core, eight-core and that, of course, all of a sudden means that we need fewer CPUs to get the same level of performance.
And most of that is related to the data center, data operations, and so forth. And so it's highly dependent upon how many of that we need to deploy.
So it was more a transition from one architecture to another and efficiency improvements than a change in strategic direction.
The next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler - RBC Capital Markets
Are you seeing higher overall conversion rates currently versus in the first half of the year and can you quantify the improvement?
Ross, we don't comment on precise metrics and conversion rates. I think the best way to think about it is to think about both from a consumer perspective and an advertiser perspective. In light of the continuing economic situation and still high unemployment, consumers appear to be acting rationally. If you look at it, when the price is right they go out and buy. So getting cash for clunkers or taking advantage of real estate incentives, but if necessary, they will buy. When you look at back-to-school purchases, they followed their normal quarterly pattern.
So I think that on the consumer side, we are seeing rational behavior. And on the advertiser side, as I mentioned earlier, the big advertisers are ramping up again, while smaller advertisers have been slower to jump back in. They were slower to leave.
So from an overall perspective, we believe conversion rates are holding up.
The next question comes from Sandeep Aggarwal - Collins Stewart.
Sandeep Aggarwal - Collins Stewart
Can you give us an update on Android adoption versus other smart phone choices? Also, how is the work on Google Chrome and it's going?
I can start with that. Eric mentioned on the prepared remarks probably the most obvious thing is just look at the scope of growth with devices, partners, carriers. You know, one device, one carrier, one country to twelve devices, twenty-six countries, thirty-two carriers in less than a year. The market is also very robust with over 10,000 applications available, which is something that we focus on very carefully. So basically the strategy of delivering a modern, open-source OS and enabling an ecosystem of developers and carriers seems to be paying off and the strategy is working.
Chrome OS is going very well. We think we're going to deliver on the goals of basically speed, simplicity and security so that computers just work and start up in a matter of seconds. And I think we will probably have more updates on that later in the year.
Let me just add. Android adoption is literally about to explode. You have all the necessary conditions. You have the vendors, you have the distribution, and so forth. And this of course is a very critical period with all of everything being delivered and new announcements as well.
From the standpoint of Chrome OS, the internal demos that we've seen indicate that it is a materially significant achievement in platform computing. It is quite different from the current incumbents in a whole bunch of ways. Speed, efficiency, and so forth. It's not quite done and we hope to get a version out later this year for people to start developing. As you know, it's an open-source initiative so we appear to be roughly on time with the announcements we made a few months about Chrome OS and obviously the anticipation just increases.
We will take the next question comes from Jeffrey Lindsay - Sanford C. Bernstein.
Jeffrey Lindsay - Sanford C. Bernstein
What are the plans for Google's large cash balances? Are stock buybacks being considered at any point?
Patrick and I were talking about who should answer this question. We have been doing very well in the cash generation front, throughout this whole year, which is a critical year. We have been able to be very strongly cash flow positive and we hope that that will continue for a long time. We love cash.
The issue with stock buybacks is historically they have often not achieved the objective that they've set out. So they are certainly none under consideration right now and I wouldn't expect any time soon. I wouldn't rule one out but I would not put it on your list of things to anticipate any time soon.
From our perspective the cash gives us a lot of operating and strategic flexibility over the very long term and so we are very happy to have it sit in our bank account and earn modest interest rates.
The next question comes from Justin Post – BAS-ML.
Justin Post – BAS-ML
What verticals, i.e. autos, travel, finance, ecommerce, has most year-over-year spending improvement in Q3 versus Q2?
If you look at our verticals across the board, auto is by far the most well-performing vertical in the U.S. for the third quarter. This is primarily due to the government's Cash for Clunkers program. If you look beyond the clunkers program, the U.S. auto vertical is still poised for growth because of the age of the U.S. fleet and auto dollars continue to sort of shift online. The U.K. also has occurred well on a year-over-year basis as far as auto is concerned.
On travel we have seen trades a bit later than usual, sort of illustrating consumer caution. Retail, we are seeing sort of a back-to-school effect that's doing well. And finance continues to be a tough vertical, given the comps from last year are tough because last year we were just beginning to get into the financial crisis, we were seeing lots of queries and all those haven't come back as well this year, as you would expect or want them to.
But having said that, there are pockets in finance which are still robust, like health insurance, or sort of insurance overall, which is primarily as a vertical.
Next we have two questions on YouTube.
The first question is from Mark Mahaney – Citigroup.
Mark Mahaney – Citigroup
What is the update on this path's profitability?
And the second question is from Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter - Broadpoint Am Tech
Can you quantify use of revenues in any way? Under what circumstances might you break out YouTube and video-related revenues for us in the future?
I will answer the front end of this question and then turn it over to Nikesh for more color commentary.
In general, as Nikesh talked about at the front end, we are really pleased about YouTube's performance. It is going very well. It is completely in line with what we discussed at the last quarter's results, which is YouTube is on its path to profitability in the not-too-distant future.
I will let Nikesh talk about all of the great partnerships that are so critical to the success, and we are having a terrific quarter on this, but just to give you one sound bite, we are monetizing more than a billion video views every week on YouTube. So if you think of that, it just gives you a sense of perspective of the success that's going on. But I'll let Nikesh give you more detail on it.
If you look at YouTube, we have primarily been able to sell pretty much home page ads across the world on YouTube, to the extent that 90% of our U.S. home page video YouTube inventory was sold out in the third quarter, which is a tremendous improvement from prior quarters. And we continue to drive forward on this ad format around the world.
As I mentioned also, we are beginning to unleash the freehold inventory which is on YouTube, making it available for our sales forces to go out and sell. So I think there are various monetization opportunities as it relates to YouTube from the ad format side.
On the inventory side, as I said, we have been able to close deals with pretty much everybody in the music label business, as I mentioned. In addition to which we also announced Channel 4 this morning, so we are creating more and more inventory so that we can create more inventory for our sales forces to go out and sell these new ad formats for.
So like Patrick, I am very pleased with our ability to monetize YouTube so far and we like the trend.
We will take the next question from Jason Helfstein – Oppenheimer & Co.
Jason Helfstein – Oppenheimer & Co.
Do you think the company can execute on its long-term growth initiatives and still keep margins flat, or should we assume the company sacrifices some margin growth to protect its dominant position and to create new growth areas?
I don't like the word dominant. I think we have great products and because we have great products and great technologies we are winning in the market. I suggest Eric also comment on it. But we are looking at each product that we are shipping to be a successful product. And if there is an investment phase for some of these products, then there is just a simple investment phase. And we are not managing the business for a percent margin at all. We are managing the business for successful products that contribute over time.
That's an interesting question, because as you know, margins have actually gone the other way from the questioner's implication and we have been able to build a great business. We do not look at margins on a percentage basis at all and we also are happy to have businesses that have differential margins as long as they are successful and provide strategic value.
So one way to think about is we do not have a margin target, we have a revenue growth target and an expense target and a net cash flow target, and they add up to whatever the outcome margin is. So we do not manage along those lines.
From our perspective, the mission of the company is to go out there and serve and also in the context, build businesses that are growing and are profitable. And we will accept whatever their native margin structures are and if the margins improve that's great and if they get worse that's okay, too, as long as we're winning in the marketplace.
The next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler - RBC Capital Markets
International revenues [inaudible] increased 19% year-over-year in Q3, an acceleration from 17% in Q2 if my math is correct. Can you provide some color on which regions are driving the acceleration?
As I mentioned in my prepared remarks, we are seeing strength across various markets around the world. As far as it relates to the Americas, Brazil has been a strong performer. We didn't see much of a slowdown in our Asia Pacific and Japan regions and therefore China has done well and other parts of Asia Pacific.
We continue to see strength in Northern Europe. France and Germany have been stable. As far as Southern Europe is concerned, Spain is seeing a revival. And we see most of these markets continue to grow well for us.
Your next question comes from Doug Anmuth - Barclays Capital.
Doug Anmuth - Barclays Capital
How do you define investing heavily in the future? More in infrastructure, products, headcounts? How will you determine how to complete a ramp spending back up?
Doug's question basically says how do you judge between the various things you should invest in, and the answer is, it depends. You use your business judgment. We know when we've got a successful product. We can tell because we measure it. And if we can see it growing, we invest to accelerate it.
We also tend to starve the projects which are not growing and try to figure out what error we made. So it's pretty straight-forward business judgment.
From our perspective, I would like us to see increasing our capital expenditures to the degree that we get competitive advantage from there. I've already indicated investment in headcount. The investment in headcount is, roughly speaking, half engineering and half non-engineering, which has been historically our model. The engineering is, for all the reasons that you can imagine. We are short key technical talent to achieve some of these broader initiatives. And the non-engineering is mostly in sales and that's frankly, quota-bearing sales people who bring in money and income in the quarter.
And on the product side, the products are really driven by the product strategy that we've talked about. And those are largely controlled by a set of operating units where they have product heads within the company who pretty much make those decisions under the supervision of Larry and Sergey.
The next question comes from Jeetil Patel - Deutsche Bank Securities.
Jeetil Patel - Deutsche Bank Securities
The underlying margin profile of the page search business is in the 58+% range. On a contribution margin basis do your display advertising initiatives carry comparable margins? Can you speak to the margin profile of the display ad business?
We just don't comment on specific product margins. So thanks for your questions, but typically we just don't comment on any of those.
The next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles - Thomas Weisel Partners
You recently removed tele outlets from your mapping product in the U.S. How mission-critical is the underlying mapping data with regard to your mobile ad strategy? What other areas of your business can help you with?
We launched the new maps data set and we're now using it in the U.S. and Mexico and we have basically built this through a wide range of sources. It includes street view, overhead imagery, the census bureau, the forest service, and what is so key here is it gives us lots more flexibility to create new types of maps.
So for example, somebody or walking or biking or tourists versus locals will want to use very different types of maps. And it also leaves us much more open to users editing through mapmaker and other feedback mechanisms.
So this is very, very significant and will allow us to launch better place pages and just make the whole process of looking at local information much better. If you think about it, behind the movie theater is a valid address in some countries, but the only way you can capture that on a map is with local knowledge, and this is going to allow us to harvest that all over the world.
The next question is from Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter - Broadpoint Am Tech
International revenues, any change to order of countries that are the most meaningful contributors to revenues? I'm trying to get a sense of where Japan and the emerging economies rank relative to the big European countries. Are Brazil or China significant yet?
Whilst we don't give out the relative rankings or the revenues of countries outside of the U.S. and the U.K. I think the best way to think about this is, as we mentioned, 53% of our revenues come from outside the U.S. and as someone earlier on the call has already done the math, that that part of our revenue continues to grow at a good pace. I did call out certain countries, so in that we have countries that grow fast, which grow very fast. And I called out certain countries which are growing very fast for us.
I think that should give you a sense of scale in terms of which parts of our business, which parts of the international market are doing very well relative to the others and over time all of the markets are relative and significant for us.
The next question comes from Brian Pitz – UBS.
Brian Pitz – UBS
Would you talk about adoption of the Double Click ad exchange by ad networks and what kind of impact? Has there been any discernable impact of pricing on the content network?
I think given the exchange this quarter, there is not enough data for us to be able to look at and be able to say these things with certainty. But if you think about all the ad exchanges already has done for us, it is already beginning to take away some pricing and efficiency from the market, because effectively you are able to collect inventory from various networks, which is unsold, which we believe is roughly about 25% of inventory in aggregate, ends up being unsold because it doesn't have a common exchange or a common place to get traded. So that's what the ad exchange actually begins to enable.
And that is the reason you are seeing many, many large networks wanting to participate in such an ad network, because they want the inventory to be sold at the best price possible. So effectively, as we can get more and more sellers to these exchanges, we have more inventory in the exchange. You will begin to see stability in price, which also allows us to create some consistency in our ability to target the ads towards the right users.
So I think overall it's going to be positive for the overall display market. It is too early to tell precisely what the impact is based on our launch this quarter.
The next question is from Mark Mahaney – Citigroup.
Mark Mahaney – Citigroup
Can you provide any commentary on how material mobile searches have been to your overall search growth, or when they could become material on a global basis? Also, what color can you provide on these searches in terms of monetization potential?
Just to give a sense that, again, we don't give the detail numbers. What we provided this quarter, which I think was a really, really statistic, is on a quarter-over-quarter basis mobile searches grew 30% on Google this last quarter.
It tells you something about the mobile space, the space of the smart phones and how they are really transformative. So the combination of the Android platform with all the smart phones and the momentum in there, as well as the iPhone and the rest of them, I mean, they're just basically transforming how people live on a mobile basis. And if you run the tape forward, I think again, another support for the Android strategy, if you have—if we move forward the adoption of these smart phones by having a lower cost infrastructure because it's open-source and you bring that, instead of taking seven years—I'm just kind of giving an illustration—all this happens in four years. Think of all the searches that will happen so much faster.
So the ecosystem is incredibly vibrant right now and truly what's interesting about these phones is there are a lot of new types of searches because you are location-specific, you are activity-specific, you are local-specific. Just a new set of areas that are to create a new set of monetization opportunities.
So it is for all these reasons that we are so bullish about it and just really investing heavily.
So that's my best answer I can give you without any specifics.
The next question comes from Spencer Wang - Credit Suisse.
Spencer Wang - Credit Suisse
You indicated that you are prepared to invest heavily again. Can expense ratios remain stable in that context or will expenses as a percent of revenues begin to increase?
Let me give you the context of why we are making the comment this quarter about investment.
I think the best way to characterize our situation is the following. Google really has been and continues to be an unconventional company that runs on its innovation agenda. I think it's fair to say that in the last 12 months—you will remember, 12 months ago we were sitting together and there was a massive crisis going on in the banking system and the economy—and this was the worst recession in like generations, if not 100 years. We decided at that time to just be prudent about navigating these unchartered territories.
As Eric said a few minutes ago, now it's clear that the banking system is not collapsing and the economy, even though many sectors are going to continue to hurt, the worst is behind us. It is in that context that I think it's important that now we go back to do what we really do well. Innovate, invest, build the future.
And that is what is really meant. And then I think that, as Eric mentioned a few minutes ago, we are really optimistic about making these investments and we are looking forward to it and that ties to both hiring and more capex and we will judge them on a case-by-case basis.
I think that is the best way to understand what's going on, really, in the company.
The next question comes from Jason Helfstein – Oppenheimer & Co.
Jason Helfstein – Oppenheimer & Co.
Give us some color on U.S. versus international paid click trends and CPCs in the quarter.
We really don't typically comment on the specifics there. We certainly saw click growth across lots of regions and CPC growth, but the main thing you have to be looking at there is the blend. It is largely impacted by the growing regions, like China, Brazil, and India where the CPCs are relatively lower.
Your next question comes from Doug Anmuth - Barclays Capital.
Doug Anmuth - Barclays Capital
Do you think your growth going forward comes more from pay click volume or pricing increases?
I think this relates to the previous question with Jonathan. I think the best way to think about this is there are still a lot of countries, a lot of parts of the world, where we are still seeing more and more people come online, which creates more searches, and therefore creates more paid click volume around the world.
At the same time a lot of our ads innovation which we are doing is going to drive some of the CPC growth in some far more mature markets.
Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell - Goldman Sachs
CPC has improved by 5% sequentially two quarters in a row with benefits from FX hedging. Does Google believe that CPC has already enjoyed most of the recovery rebound or is CPC still a sub-trend?
We don't comment forward, so we were really pleased with, as Nikesh said, in a way our revenue really reflects what's going on in the economy from the consumer side and from the advertisers' side and it's a great question as to what the coming quarters are going to look like.
To give a better color commentary on this, what's really interesting about Q4 this year is if you think about everything that happened last year, year-over-year comparisons are going to be really interesting. So, for example, last year there was a flood of inventory that needed to find a home so discounting was quite dramatic. And coupons were everywhere. This year it's a different story with inventory at an all-time low and people prudent. It will be interesting to see.
So rather than to give you any kind of answers as to how we see the future, I think it's really important that people have a mental model of how they think the economy is going to rebound and everybody has their own view, but we don't comment on perspective.
Your next question comes from Jim Friedland – Cowen & Company.
Jim Friedland – Cowen & Company
The Google sites tax rate was down quarter-over-quarter, 6% to 5.8% for the first time. Are you pulling out of some site traffic acquisition deals? Are you renegotiating contracts? Has the sites tax rate finally stabilized?
Every deal is done on a deal basis and they are all profitable. We look for a great partnership. We are not pulling out of any great deals. We just work with each of our partners. We are delighted to have so many partners. And every deal that makes sense we actually do together. Sometimes you have deals that either expired or didn't have the right mix so you may have fluctuations like you had this quarter but I wouldn't read too much into it.
We are going to take one more question and that's from George Askew - Stifle Nicolaus.
George Askew - Stifle Nicolaus
How rapidly do you expect headcount to grow over the next two years?
I'm going to steal thunder from two conversations Eric and I have, and it's been about if you think about everything we've looked through together over the last year, it would have been great to continue to hire even sooner. So in that sense we are delighted that we are able to now continue to fund for investing in our headcount resources and then you still have to kind of make sure that—you know, it's not about headcount, it's about finding the people that fit in the Google culture, the best engineers, the best minds and as we find them we hire them. So it's more a function of finding these fits rather than to put quotas on a quarterly basis. And that's why this quarter we had a bit of a retreat—just a 100 kind of so at Google—but it's not because we were trying to shrink, it's just you have to find the right Googler.
In terms of recruiting, I think we do it well, so we will grow it whatever way we can.
That wraps up the Q&A portion. Again, we are trying something new this quarter so we would love to get your feedback. And now I'm going to turn the call over to Eric.
Just to finish up, I hope it's clear that we're very happy with the quarter. We believe we now have the confidence in our underlying business and the business trends to begin to get back, to do the kinds of things that we do so well and that we really see as our mission, which is to make the world an information-rich place, to build some of these new businesses, and really serve our customers very well.
So with that, thank you all very much.
This concludes today’s conference call.
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