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Google's (NASDAQ:GOOG) stock plunged recently after management announced that the search giant’s profit margins had declined during the second quarter of 2010.

Google’s EBITDA margins shrank from 54.3% in the first quarter of 2010 to 51.7% in the second quarter. Google executives attributed the margin decline to increasing headcount leading to higher R&D and SG&A costs, as well as to revenue losses related to the European debt crisis.

We believe that Google’s margin decline will be temporary, and will not impact our  $677 estimate for the company’s stock. Our analysis follows below.

Downside Impact

Google competes with Microsoft (NASDAQ:MSFT), Yahoo (NASDAQ:YHOO) and AOL (NYSE:AOL) in the search advertising market. We estimate that Google’s search advertising business constitutes about 73% of the $677 Trefis price estimate for Google’s stock.

We expect Google’s EBITDA margins in the search business to decline slightly from around 60% last year to 59% in 2010, and then stabilize over the long term. But if margins decline to around 50% by the end of Trefis forecast period, there could be a downside of 10% to our estimate. Drag the line in the chart below to modify our EBITDA margin forecast and see its impact on Google’s stock price.

Why Google’s Margins Shrank

1. Headcount increase

Google added 1,200 employees in the second quarter of 2010, including 300 employees of Admob, a mobile advertising company that Google acquired during the quarter. These additions increased Google’s operating costs and squeezed margins.

In the long run, we believe will allow Google to keep innovating and increase its share of an increasingly competitive search market.

2. European debt crisis

Google gets about one-third of its revenues from Europe. The recent European debt crisis hurt Google’s revenues. As a result, overall revenues increased by only 0.7% in Q2 2010 over Q1 2010. We believe that Google’s European revenues will recover as the sovereign debt crisis subsides.

Disclosure: No positions

Source: Google’s Margin Squeeze Won’t Hurt Long