Google Sell-Off Offers Opportunity

Google Inc. (GOOG) surprised everyone last night when they missed earnings estimates for just the second time in the 12 quarters since going public by posting earnings of $3.56/share (when you take out costs for employee stock compensation).

That was three cents shy of analyst estimates and well below the whisper number of $3.75. Call it a case of not meeting lofty expectations from perhaps the most admired company in the world - as well as higher one-time costs, which I'll go into below. So, just as traders did after the bell, time to head for the exits right? No!! Maybe I'm a glass half full kind of guy, but after reading through the reports and the entire transcript (thank you Seeking Alpha) I still feel good about Google and see this sell-off as opportunity, not as a reason to head for the exits.

Let's run through the highlights of the quarter:

First the good….

- Revenue came in at a 58% increase over the year ago period which beat analyst estimates. No problem here.

- Revenue generated from Google.com properties grew an impressive 74% year over year and 9% sequentially. It was driven by global traffic growth and higher quality advertising.

- Adsense revenue increased 36% year over year, but was flat sequentially due in part to seasonal trends but also due to the company canceling accounts of unfavorable publishers (ie. made for adsense spam sites).

- International growth fueled by Europe now makes up 48% of revenues

- Traffic acquisitions costs decreased to 30% of total revenue, down from 31% in the first quarter

.. and the not so good …

You can see on the revenue side it was a great quarter. The problem was in the earnings per share number, which was driven down below expectations due in part to much higher than anticipated costs associated with rampant hiring and what appears to be a higher one time cost associated with a revision of the employee bonus accrual methodology. This led to a higher bonus accrual for this quarter.

Rampant Hiring

The number of new hires increased to 1548 this quarter, compared to 1152 in the year ago quarter. That's a whole lot of additional on site hair cuts, catered meals, oil changes, dry cleaning and whatever else it is that the company famously provides … not to mention stock options and bonuses. A few quotes:

"A second factor driving expenses was headcount growth, which led to higher payroll expenses. We added 1,548 employees in Q2, the majority in sales and marketing and engineering," said CFO George Reyes.

CEO Eric Schmidt acknowledged they will be more careful about hiring in the future:

From a Google perspective, when we look at the quarter, one area we exceeded over our expense plan was headcount. We are very pleased with the talent that we've brought on board, but going forward we will watch this area very closely.

Higher Bonues Accrual

This is the one part of the transcript that in my opinion, stood out the most and a big reason why I feel that the earnings miss this quarter was an aberration and not the beginning of a trend. If you read the transcript, you'll see that analysts were keying on this as well. Some quotes…..

"One of the larger drivers of payroll expense was the company bonus plan. This was due in part to a revision of our bonus accrual methodology that will allow us to more proportionately recognize the related expenses each quarter. This all led to a higher bonus accrual in Q2, which includes a catch-up from Q1, and affected all expense line items…going forward, it should be a more normalized bonus accrual process. This was just sort of a one-time inflection that we tried to do to true-up the bonus , " said CFO George Reyes.

CEO Eric Schmidt:

In general, we don't break out all the puts and takes on the changes in the accrual. What I would tell you is that we overspent against our own plan in the area of headcount, and some of it was related to this bonus accrual that I talked about; and some, because we hired a little faster than we had planned. In looking at it we thought, was this a mistake or not? We decided it was not a mistake, that in fact the kind of people we brought in are so good that we're happy we did this. As I said earlier, we will continue to watch this very carefully in the future.

Conclusion

Google is a company that has seen a deceleration of its growth every quarter for over two years now, so that trend continuing is no surprise given the billions upon billions this company now generates every year. It's just flat out difficult to maintain the kind of growth they were achieving. At some point, and I think that is beginning to happen, the company will settle into quarter over quarter growth of 30 - 40%, which is outstanding for a company of this size. Yes, it's time for Wall Street to lower expectations a bit and this quarter miss should go a long ways in achieving that. All in all, it was another great quarter tarnished a bit by what appear to be one time costs. This sell-off, in my opinion, will offer opportunity.

I personally held my long term position in Google through this earnings report and will look at this dip as a buy opportunity. However, I won't jump into it right away. It's going to take some time for traders to sort out this report and for analyst to issue their reports. Once trading volume subsides to more normal levels and we get a clear idea of where exactly this stock will find support, I will be looking to add shares in this outstanding company.

Disclosure: Author is long GOOG.

Comments

[Ralph F]

You're right that the fundamentals are still v good, but I think William Trent is more realistic on the stock:

Google's Miss: A Wakeup Call For Investors

[JohnOlagues]

Tate:

You mention a figure of 3.56 earnings per share ( if you take out costs of employee stock compensation). In 2006 Google employees and executives exercised 8,128,000 Employee stock options when the average weighted exercise price was $66. The average price of Google shares during 2006 was $424 making it such that employees and executives took home about 2.9 billion. This 2.9 billion was written off from Google's income for tax purposes, whereas Google reported a 393 million expenses (artificially understated) against earnings for their stock options costs.

So Google made 3.56 if you don't count the the FASB required "Fair Value" costs and certainly not the actual costs. If you counted the actual costs, Google has no earnings at all.

John

[Tate Dwinnell]

Ralph, William doesn't mention the bonus accrual or the acceleration of hiring.. these are very important components to the earnings miss and will be less of a factor next quarter. Also keep in mind that this is a company that is building out infrastructure at a torrid pace. What happens after the infrastructure is in place and all the pieces come together? Bottom line is that we have only seen the beginning of what this company is capable of. Moderating growth isn't surprising for a company this size so I would agree that we need to lower expectations a bit in the future but all the pieces are coming together for Google to dominant the web just as Microsoft dominated the desktop.

[bobbyjoe]

Are they building a platform to boost earnings in the future?

Or will growth moderate, for a company this size?

Either growth will moderate (because of Google's size) or it will not moderate (because they are currently building a platform for future growth).

You can't have both.

[Brian Croner]

They invested all their available extra dimes in talent. 1500 hires, meaning probably 400+ specialists to hit the new field. They said they're proud of their talent acquisition, and they're going to watch that area very closely. It's all about what the skilled workers can do for them.

Paycheck programmers earn their paychecks. A true engineer does it to be himself or herself. Depending on the level of talent Google demands out of their newfound hires, they could be alright. Make no mistake about it. For somebody who really can do the engineering work right, information thief Google's money is currently no greener than propagandist Rupert Murdoch's money.

A transcending feeling among merited engineers about corporate employers is they don't care about you, so don't be so fooled as to care about them. These employee perks won't buy the trust you need out of the talent you want, unless you're okay with the work of a paycheck programmer.

[sufiy sufiy]

Google GOOG Earnings and Growth are Falling further
The most important ring bell for all Google shareholders should be falling by 12% margin from almost constant before 33% to 29% of revenue. With increase in revenue of 58% Y/Y Google demonstrated falling growth rate of -25% Y/Y. Google network growth is falling even more faster by -38% Y/Y due to heating up competition. Net Income actually fall from 1billion to 0.9 billion comparing to the 1st q 2007. Total cost and Expenses are growing 116% faster then revenue growth rate Q/Q. Sales per head is down by -6%. With all this deteriorating fundamentals investors still were ready to pay last Thursday 548.59 which brings Google to valuation of P/S=12.9, P/E=47, P/FCF=74. Even if Google...




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