Here’s the entire text of the prepared remarks from Google’s (ticker: GOOG) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Eric Schmidt, Chief Executive Officer
George Reyes, Chief Financial Officer
Larry Page, Founder and President, Products
Sergey Brin, Founder and President, Technology
Omid Kordestani Senior Vice President, global sales and business development
Jonathan Rosenberg, Vice President, Product Management
Paul Keung at CIBC World Market
Heath Terry with Credit Suisse First Boston
Safar Rashtchy with Piper Jaffrey
Anthony Noto, Goldman Sachs
Christa Quarles, for Thomas Weisel Partners
Robert Peck with Bear Stearns
Marry Meeker of Morgan Stanley
Imran Khan of JP Morgan
Marianne Wolk, Susquehanna Investment Bank
Mark Mahaney, for Citigroup
Jeetil Patel with Deutsche Bank Securities
Scott Kessler with SMP Equity
Benjamin Schachter from UBS
Good day everyone and welcome to the Google Inc. Third Quarter 2005 Earnings Conference Call. This call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Ms. Kim Shevel Google Finance Director. Please go ahead.
[Kim Shevel, Finance Director]
Thank you, good afternoon. Welcome to our Third Quarter Earnings Call. On the call today are Eric Schmidt, Chief Executive Officer, George Reyes, Chief Financial Officer, Larry Page Founder and President Products, Sergey Brin, Founder and President, Technology, Omid Kordestani Senior Vice President, Global sales and business development and Jonathan Rosenberg, Vice President, Product Management.
This call is being webcast from our investor relations website. Additionally our press release issued few moments ago, is now posted on our website. A replay of this call will be available within a few hours. Some of the statements we will make today our forward-looking, including statements regarding expected capital expenditures for 2005. Our operational performance and margins the prospects of growths in online advertising are continuing ability to grow and innovate. Our expected traffic growth, the growth patterns of our AdSence network and our Google websites. The potential for the services we develop to benefit our users and partners. The expansion of our China operations and other international operations, our expected investments in our business and our expense growth, our future provision for income taxes and our effective tax rate. Our plans with respect to providing, wireless internet access to San Francisco, our expectations with respect to our print ad business and strategic relationships and our potential development of land at Moffett Field.
These statements involve a number of risks and uncertainness that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainness include a variety of factors, some of which have beyond our control. These forward-looking statements speak as if today, and you should not rely on them as representing our views in the future. We undertake no obligation to update forward-looking statements to reflect events or circumstances that occur after this call. Please refer to our SEC filings including our report on Form 10-Q, for the quarter ended June 30th 2005, for more detail description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relation section of our website.
Also, please note that certain financial measures we use on this call, such as EPS, net income, operating income, research and development expense, adjusted EBITDA and free cash flow will be expressed on the proforma non-GAAP basis and have been adjusted to exclude charges related to Stock Based Compensation or SBC and In Process R&D or IPR&D.
Beginning this quarter, we will report our GAAP results as well as provide non-GAAP operating income, net income and EPS on a supplemental basis in our earnings release. Reconciliation’s of all non-GAAP financial measures to GAPP financial measures are also included in the earnings release which may be obtained by visiting the investor relation section of our website. And with that I would like to turn the call over to Eric.
[Eric Schmidt, Chief Executive Officer]
I would like to thank everybody for joining us on our third quarter 2005 conference call. It is a great to talk with you after our very successful second year and a very strong quarter. What I will do is I will give you a couple of introductory comments and then we will have George will take us through the number as he always does Larry and Sergey will join us with the some comments about what we did in the quarter. And we’ve also asked Omid and Jonathan, previously introduced to join us as a part of Q&A to provide you more depth into our business corporations.
As you probably are seeing from the press release, we had another strong record-breaking quarter in terms of both revenues in profits and we are very, very pleased obviously. This is traditionally a slower season for Internet properties. But this momentum shows at least from my perspectives that we are effectively connecting with our users and our customers in a relevant and meaningful way with all of our existing and new products that we brought out. As you said from the beginning our focuses is still in the long term, results we’ve achieved, may or may not, of course reflected any forward quarter. In the near term we are attracting a lot more business fortune 500 companies and continue to build our index. We believe the Research and advertising industries remain in the nascent stages of growth with great forward potential. We are going to continue of course our policy of no forward guidance, as you all would expect, so George why should go ahead and take us through the numbers.
[George Reyes, Chief Financial Officer]
Thank you Eric. Before we dive into our Q3 results, I would like to discuss our new reporting format. For the first time this quarter we are providing non-GAAP proforma earnings as a supplement to our earnings reported on the GAAP basis. This quarter, non-GAAP earnings excludes charges related to stock based compensation and IPR&D as Kin suggested earlier. We believe that these and other non-GAAP measures will provide meaningful supplemental information, regarding our performance and our liquidity. In our earnings release we will include reconciliation’s to GAAP for all of these measures. So having said that, let’s get started.
We are extremely pleased with our results for Q3. As we’ve said before Q2 and Q3 traditionally are slowest quarters and we are quite happy with the 14% sequential revenue growth we were able to achieve this quarter, as our top line grew to $1.578 billion from $1.384 billion, last quarter. Year-over-year revenues nearly doubled with an increased of 96%, compared to Q3 ‘04. GAAP operating income in the quarter was $529 million this compares to GAAP operating income of $476 million in the second quarter, an increase of 11%.
Non-GAAP operating income for the third quarter was $596 million this compares to $523 million in Q2 of 2005, an increase of 14%. GAAP net income for the third quarter of $381 million as compared to $343 million in the second quarter, an increase of 11%. Non-GAAP net income for the third quarter was $437 million as compared to $381 million in the second quarter, an increase of 15%. GAAP earnings per share for the third quarter was $1.32 and 290 million diluted shares up outstanding, compared to $1.19 for the second quarter on 287 million diluted shares outstanding. Non-GAAP earnings per share for the third quarter was $1.51 and 290 million diluted shares outstanding compared to $1.33 for the second quarter of 2005 and 287 million diluted shares outstanding. Non-GAAP operating income, non-GAAP net income non-GAAP EPS were all proforma measures, net of stock based compensation and IPR&D charges.
This quarter is the stock based compensation charge was $46 million as compared to $47 million in the second quarter of 2005. The IPR&D charge was $21 million in this quarter with no IPR&D charge in Q2. The IPR&D charge relates to an acquisition in the third quarter. GAAP tax benefits related to stock based compensation charges had been excluded from non-GAAP net income and non-GAAP EPS. The tax benefit related to stock based compensation totaled $11 million in the third quarter and $9 million in the second quarter.
Net cash provided by operating activities was $647 million for Q3 compared to $625 million in Q2. Adjusted EBITDA and by adjusted we mean net income before interest taxes depreciation, amortization, IPR&D and stock based compensation increased 14% to $672 million a roughly 43% of revenues in Q3, up from $590 million were again roughly 43% of revenue in Q2 of 2005.
Capital expenditures for the third quarter totaled $293 million compared to a $157 million during the second quarter of this year. We are now at the estimating over $800 million in capital expenditures for 2005.
Let us now dive into more of the details around those revenue and cost. Let’s start with revenues. As I mentioned total revenue grew to just under $1.6 billion this quarter. Our own Google sites again continue to grow faster in the Google network, showing sequential growth of 20% as compared to 7% sequential growth for the partner network. Revenue from our own sites increased to $885 million in Q3, from $737 million in Q2 and represented 56% of total revenues this quarter, as compared to 53% in Q2. Revenue from the Google network the third party sites to display ads provided by Goolge increased to $675million in Q3, from $630million in Q2. The network represented 43% of total revenue compared to 46% last quarter.
On the international front our key area of investments for us will continue to make study progress. This quarter international operations contributed 39% of total revenue, compared to 39% last quarter and 35% in Q3 above Q4. The UK contributed 15% of the total revenues this quarter as compared to 14 % of total revenues, last quarter.
As we’ve discussed in the past Q4 and Q1 are the strongest quarters for the online advertising industry and for an Internet usage, while Q2 and Q3 are traditionally weaker with Q3 being generally the weakest. This years Q3 revenues came in stronger than we originally expected, due primarily the product improvements. This growth more than offset the expected seasonal slowdown in the traffic.
As you might imagined, it has been difficult for us the forecast the rate of product innovation and the impact it will have on our revenues. As you consider future estimates, bear in mind, that we will continue to release product improvements with varying levels of impact on revenue and that impact will continue to be difficult to predict. Many of our product improvements are intended solely to improve the user experience and may or may not be accretive to revenue in the short-term.
Let us shift gears and then talk about cost and expenses. At Google starting with the cost of revenues, cost of revenues is comprised of traffic acquisition cost, credit card processing charges, the cost associated with the data centers, amortized expenses, which includes purchasing licensed technologies.
In the quarter this cost increased to $654 million from $597 million in the second quarter but, decreased as a percentage of revenue to 41.4% from 43.1% in the previous quarter, primarily due to our reduction in TAC as the percentage of revenue, which I will discuss next. TAC with the revenue share with Google partners increased to $530 million Q3, from $494 million in Q2. TAC as the percentage of web of advertising revenue, decreased from 36.1% in Q2 to 34% in Q3. The decrease is related primarily with the continued shift in our revenue mix from the Google network revenue to Google site revenue.
In Q3 of 2005, R&D spending increased to $152 million from $96 million in Q2 or 9.6% of revenue, as compared to 6.9% of revenue last quarter excluding IPR&D charge of $21 million non-GAAP R&D total $131 million or 8.3% of revenue. The increase in R&D is due primarily to our successful engineering recruiting efforts. As we have stated for the last few quarters you should fully expect to see growth in this expense line for the foreseeable future.
On the sales and marketing front, sales and marketing expenses decreased from 7% last quarter to 6.7% this quarter expressed as the percentage of revenue. In absolute dollars spending increased 8% to $105 million from $97 million last quarter. This increase in spend reflects natural growth of headcount and expenditures as we grow our business globally.
On a G&A front, G&A increased $92 million in Q3 and $72 million in Q2 of 2005, an increase of 29%. On a percentage of revenue basis G&A increased to 5.9% from 5.2% last quarter. This growth primarily reflects headcount increases in IT operations, human resources and recruiting and finance and legal, which continue to be necessary to support the scope and scale of the business growing at our current phase.
With the respective of the stock based compensation, stock based comp charges fell slightly this quarter to $46 million from $47 million last quarter, this number includes the smaller amount of stock based compensation related to stock option rewards issued previously but, now a growing component of stock based compensation, associated with grants of restricted stock units, what we call the GSU’s. Our non-GAAP results are net of these charges.
Turning to operating margins, non-GAAP operating margins in the third quarter was 37.8% of revenues compared to also 37.8% of revenues in the second quarter. Increases in R&D and G&A spending as a percentage of revenues, were balanced by growth in higher margin google site revenue resulting in steady state margins, quarter over quarter.
Please know that as we have said in all of our publics filings and as Eric has mentioned earlier, we intended to invest aggressively in our business, when see opportunities we believe will pay of in the long-run, regardless of the short-term characteristic of the business. Our investments will be made in a thoughtful and measured manner.
Let’s now move to the income tax line. Our effective tax rate remains steady at 31% this quarter and continues to reflect the mix of business generated in the US and the business generated through our IR subsidiary. A provision for income taxes was not materially affected by stock option activity, although we did realize a $105 million reduction in our income taxes payable as result of this activity.
We expect our effective tax rate to be approximately 30% for the full year of 2005 and we believe we should be able to maintain or reduce this rate in the long term. However in the future earnings recognized by our IR subsidiary are not as proportionally greater as we expect or our effect tax rate will be higher than our expectations. In terms of foreign exchange we experience the $23 million unfavorable impact to our revenue line from Q2 to Q3, as a result of an increase in the value of the dollar, the US dollar primarily against the Euro.
Turing to liquidity front, net cash provided by operating activities for Q3 totaled $647 million as compared to $625 million for Q2. Free cash flow another alternative measure of liquidity is defined as cash provided by operating activities less capital expenditures. This quarter we generated $354 million in free cash flow. Our capital expenditures in the quarter were $293 million compared to $157 million last quarter and primarily reflect acquisition of additional land and office space to support our headquarters in Mountain View, California, as well as the purchase of production services and networking equipment. As I suggested previously, we are now estimating capital expenditures for 2005 of roughly $800 million.
Our cash, cash equivalents and marketable securities balance of just over $7.6 billion at September30, up from $2.9 billion at the end of last quarter. The increase is primarily attributable to our follow-on equity offering in which we raised $4.3 billion, to support the future growth of our business.
Under DSO front, DSOs increased slightly to 31days from 28 days last quarter. This increase reflects the growth of our international business where credit terms tend to be longer, as well as extended credit to certain customers in United States. On a worldwide basis we grew to 4,989 full-time employees, as of September 30th as compared to 4,183 as of June 30th and 2,668 as a of September 30th 2004. Before turned it over to Larry, I would like to update all of you, with respectable Google foundation. We have pledged a $90 million cash contribution to our foundation in the fourth quarter. As this is a non-recourse, non-refundable donation, it will be recorded as an expense in Q4 and presented as a separate line item on our P&L.
We don’t expect to make further donations for the foundation for the foreseeable future. Over the next 20 years we plan to donate or invest roughly 1% of our equity as of the IPO date, this equates to 3 million shares. These shares are the cash equivalence will be donated/invested overtime in the Goolge foundation. The $90 million cash contribution in Q4, equates to roughly 300,000 shares. Therefore, roughly 2.7 million shares of the 3 million allocated will remain available for investment in the foundation.
In addition we plan to donate or invest 1% of our profit on an annual basis. We may also make investments in four profit enterprises with a social objective. These equity investments will be recorded on our balance sheet, to the extent they become impaired we will have to recognize the appropriate write downs on those investments when and if they occur. And with that I would like to turn the call over Larry.
[Larry Page, Founder and President, Products]
Thank you George. Last quarter we gained a lot of momentum in our goal to make the world’s information universally accessible and useful. We are very happy with our progress interjecting quite a new number of new products and services. We celebrated our 7th birthday in September, by launching a significantly expanded search index about a thousand times larger than the index, when we started. That makes Google three times larger than any other search engine, by our estimates. We’ve also done more work to personalize Internet experience, with freely downloadable application like Google Desktop-2 and Google Talk.
Desktop-2 as the Desktop Outlook Search, and a sidebar that is always there and gives you a snapshot of personalized information, like email, weather and photos in real time. Google Talk is an instant text and voice-messaging toll based on the open network.
Google Local and Maps have been combined so, people can get a local search mapping information at one place. Google (2023) gained popularity since it came out in June and in September we updated with data the index stories and images from national geographic. We announced enhancement, to Google Video and Blogger. Google Video is now available on more platforms for better viewing windows and controls without having to download any special Google software. And now we have Google Logsearch, a new service based on Google search technology that lets users search for blogs and post. We introduced some new enterprise level of products and services, companies can offer Google desktop search on their employees computers and we lower the price of the Google mini, as small businesses can get a enterprises global search solution, at a better price.
Getting people corrected information wherever they are continues to be a focus area for us. One highlight is a bid we’ve submitted to offer free WiFi wireless Internet access to the City of San Francisco. This is an opportunity to make services growth touch counts for new location based technology. Finely we continue to work hard on Google Print. This is an effort to create a giant card catalogue of books online. Google Print searches and stores snippets of the book and mostly have the publishers or author’s permissions to show more. This effort will ultimately help authors and publishers, to sell more book and users everywhere find the information they are looking for. Now I will turn the call over to Sergey.
[Sergey Brin, Founder and President Technology]
Thank you Larry. I have a few things to cover, including updates on our advertising programs some key hires and industry collaborations and an update on Google.org and the Google foundation. Advertising continues to drive most of our business and will continue to expand our advertising products. The site targeted at advertising program we launched in Q2 has been widely adopted. More than 25% of the Google’s top 100 advertises have run a site-targeted campaign and the feedback has been positive. We are continuing to test the placement of adds from our vast advertising network into select US print publications to connect publishers and advertisers. Ads from this program are currently running in PC Magazine and Maximum PC and 100s of other publications have expressed interest in participating.
Internationally we launched Picas International and we extended our advertising sales and operation forces into several new territories. We’ve opened our sales office in Stockholm and plan to open offices in Tel Aviv and Poland. There were number of announcements from China including an new authorized reseller program and Google Local for China, as well as Google University Search and Google Public Search. These services offer free access to search for Universities.
In Q3 we completed over 20 new deals including Univision.com and Sun and renewed over 20 of partnerships to distribute AdSense and search services round the world. Our agreement with Sun will allow millions of people who download the Java runtime environment to get the Google toolbar and we look forward to working with them to find more ways to extend our mutual technologies.
Our recent announcement with NASA Aims Research Center, to collaborate on four areas of technology, also includes provision for Google to develop up to 1 million square feet of land at Moffett Field. We are working on our preliminary plans and will keep you updated as things progress.
We also look forward to working with a number of other projects. You may have seen some coverage on our initial investment into Google.org, philanthropic effort effort we discussed in our annual report. Under the umbrella of Google.org, we’ve created the Google foundation and have funded that with $90 million. As George mentioned this doesn’t hits the books until Q4, but we want to mention it because this is an important first step in our commitment to donate 1% of our equity and profits towards philanthropic efforts. This commitment is going to reflect the broader Google.org structure we have created in which the Google foundation in just one part, although that part is one that received $90 million right now.
I would also like to highlight several editions to our team in the past few months. Dr Kaifu Lee has already started working on our new R&D center China and we welcome Dr. Vint Cerf one of the fathers of the Internet as our Chief Internet Evangelist and Dr, Shirley Tilghman, the President Winston University is our newest board member, Eric, over to you.
[Eric Schmidt, Chief Executive Officer]
Well thanks very much you all. So, let’s finish up here and get your questions and we had another exceptional quarter beside our expectations going into it. We are very much sticking to what we said in our original founders letter about continuing to focus on users and the quality for information and advertising that they all need. What I am particularly happy about this, we are happy about this is how well its working at this scale. Internet access is becoming so ubiquitous, so practical our lives are continuing to move online and changed the way we’ve been doing business. We focused on accesses to the information as much as the search itself, because you need both. To reach this reality people are increasingly demanding more intrusive personalized technologies and we are building them.
We believe that the most direct way to access walls of information is and will continue to be through Google. I encourage you to view our results as driven by a business model, for instant and seamless access to the world information, driven by the most relevant and complete set of information and that’s people really care about. And we are obviously have been able to innovate because we built quite a talented team and enough computing power to enable it. Thank you for continuing to travel this road with us, if you excuse the metaphor, actually, we are to become the leading provide of access to the world information. If you look our US operation, international operations, you can see us really working very well. So, with that Larry, Sergey, Edward, Jonathan, Omid and I would like to take your questions one at a time. If there is time after everyone had a first chance we will of course come back with any follow up questions. So, operator can you begin the first question.
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