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Google, Inc. (NASDAQ:GOOG)
Q4 2005 Earnings Call

Executives:

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

Analysts:

Heath Terry, Credit Suisse First Boston
Anthony Noto, Goldman Sachs
Robert Peck, Bear Stearns
Marry Meeker, Morgan Stanley
Mark Mahaney, Citigroup
Lauren Fein, Merrill Lynch
Mark Gray, Needham & Company
Scott Kessler, Standard and Poor’s
Troy Maston, William Blair & Company
Jordan Rohan, RBC Capital Markets
Douglas Enmuth, Lehman Brothers
Yousef Squalin, Jeffries and Company

Presentation

Operator

Good day everyone and welcome to the Google Inc. Fourth Quarter 2005 Earnings Conference Call. This call is being recorded. With us today from the company is the chief executive officer. Dr. Eric Schmidt, the co-founder and president of technology Mr. Sergey Brin and the Co-founder and President of products, Mr. Larry Page and the Chief Financial Officer, Mr. George ?. At this time I would like to turn the call over to Miss Kim Shevel, Director of financial relations.

Kim Shevel, Finance Director

Good afternoon. Welcome to our 4th quarter 2005 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 Market Management. This call is being web cast from our investor relations website.

Additionally, our press release issued a few moments ago is now posted on our website. A replay of this call will be available within a few hours. Some of the comments they will make today are forward looking including statements regarding our operational performance and margins, the prospects for growth in online advertising and our business, our continuing ability to grow and innovate, our expected traffic growth, the growth of patterns of our absence network and Google website, the potential for the services we develop to benefit our users and partners, the brand expansion of our international operations, our expected investments in our business, the nature of expected capital expenditures for 2006, our expense growth, our expected stock-based compensation expense, the expected dilution related to equity grants to employees, our future provision for income taxes and our effective tax rate, our planned investment in socially or economically progressive measures our expectations with our sector and mobile business, our strategic relationships including our planned acquisition of DMARC and our relationship with AOL and the rate of introduction of new products and services.

These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control. These forward-looking statements speak of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these forward looking statements to reflect events or circumstances that occur after this call.

Please refer to our SEC filings including our report on form 10K, for the year ended December 31, 2004, and our report on form 10Q for the quarter ended September 30, 2005, as well as our earnings release posted a few minutes ago on our website, for a more detailed 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 relations section of our website.

Also, please note that certain financial measures used on this call such as EPS, Net Income, Operating Margin, operating Income, Adjusted EBITDA and free cash flow, will be expressed on a 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 as well as contribution to the Google Foundation in the 4th Quarter.

We report our GAAP results as well as provide non-GAAP, operating income, net income, operating margin, EPS, adjusted EBITDA and free cash flow on a supplemental basis in our earnings release.

Reconciliations of all non-GAAP financial measure to GAAP financial measures are also included in the earnings release, which may be obtained by visiting the investor relations section of our website. And with that, I’d like to turn the call over to Eric.

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Eric Schmidt, Chief Executive Officer

Well thanks very much, Kim. I’d like to thank everybody for joining us on the call today. I’ll begin with some introductory comments and then turn it over to George for some more detail on our financial results. After George goes through the numbers, Larry and Sergey will comment on the quarter and some of the initiatives that we have underway. And after that we’ll have Omid and Jonathan join us as they did last quarter, to take your questions.

I’d like to remind everybody that our policy is not to give any forward guidance and we are going to continue that policy for the indefinite future.

We are very pleased with these results and hope that you’ve had a chance to look at the press release already. We had very strong growth in our core search and our core ad business. 22% quarter over quarter growth and 86% topline revenue growth since Q4 ’04. We saw and in fact delivered expected and in fact delivered seasonal strength in both traffic and monetization, all very good indicators for the future.

Our focus at Google is on the end-user experience and frankly more and more time that people spend online will be spent using Google online in one way or another. And the products and improvements that we make are geared toward enhancing user quality and really changing the way people use this sort of amazing thing that is the internet. This approach, the end-user experience, is the core to our culture and to our recruiting efforts and the way we manage the company. We see very tremendous opportunity for growth at this point. We have new, innovative products that deliver the value to our technology into different channels. It looks, based on our analysis, that the international markets are highly under penetrated, with tremendous forward growth, as we build out our operations there, and we’ll talk about that some more.

The expansion of our advertising network continues apace, continues to be very, very strong. But perhaps most important, we believe the rate of innovation will increase in 2006 as we continue to bring the most talented minds into Google and our unique innovation model delivers amazing new products.

So we take a long term view of the business and we’re going to invest for the long term and make some really big bets. So with that, let me turn it over to George to take you through the exact numbers.

George Reyes, Chief Financial Officer

Thank you, Eric. First, I will go through 4th Quarter results in detail, and then summarize our annual results. But before we get started, as a reminder, we report both GAAP and non-GAAP financial measures. Non-GAAP earnings exclude charges related to stock-based compensation, in-process research and development and a contribution to the Google Foundation of $90 million. In our earnings release, we have included reconciliations to GAAP for all of the non-GAAP measures, including EPS, net income, operating income, operating margins, adjusted EBITDA and free cash flow. So let’s jump in and get started.

As Eric mentioned, we achieved strong revenue growth during the 4th Quarter. Revenue grew to $1.919 billion, an increase of 22% over the 3rd quarter and an increase of 86% year over year. GAAP operating income in the 4th Quarter was $570 million. This compares to GAAP operating income of $529 million in the 3rd Quarter, an increase of 8%.

Non-GAAP operating income for the 4th Quarter was $718 million. This compares to $596 million in the 3rd Quarter an increase of 20% sequentially. GAAP net income for the 4th Quarter was $372 million, compared to $381 million in the 3rd Quarter. Non-GAAP net income for the 4th Quarter was $469 million, compared to $437 in the 3rd Quarter. GAAP earnings per share for the 4th Quarter were $1.22 on 305 million diluted shares outstanding, compared to $1.32 for the 3rd Quarter on 290 million diluted shares outstanding.

Non-GAAP earnings per share for the 4th Quarter were a $1.54 on 305 million diluted shares outstanding, compared to $1.51 for the 3rd quarter of 2005, on 290 million diluted shares outstanding.

Non-GAAP operating incomes, non-GAAP net income and non-GAAP EPS are all pro-forma measures, computed net of certain material items, namely stock-based compensation, in-process research and development charges, and the contribution to the Google Foundation of $90 million made in the 4th quarter of 2005. In Q4, the charge related to stock-based compensation was $58 million, compared to $46 million in Q3. In-process research and development charges were immaterial in the quarter, compared to $21million in the 3rd quarter. GAAP tax benefits related to stock-based compensation charges and the contribution to the Google foundation have been excluded from non-GAAP net income and non-GAAP EPS. The tax benefit related to stock based comp was $14 million in the 4th quarter and $11million in the 3rd quarter. And the tax benefit related to the contribution to the Google foundation in the 4th quarter was $37 million.

Net cash provided by operating activities was $658 million for Q4, compared to $647 million in Q3. Now, I’ll go into some more details on revenue and expenses.

As I mentioned a moment ago, total revenue grew 22% sequentially, and 86% year over year to $1.919 billion, demonstrating the continued success of our advertising solutions. Revenue growth was driven by expected seasonal gains in both traffic and monetization. Both Google.com and the Google network experienced strong growth during the quarter. During Q4, the mix in revenue continued to shift toward Google.com sites, as revenues from our Google sites increased 24% sequentially to a record $1.098 billion. While revenue from the Google network, third party sites that display ads provided by Google, increased 18% over Q3 to $799 million. Revenue from our own sites represented 57% of total revenue in the 4th quarter as compared to 56% in Q3. And revenue from the Google network represented 42% of total revenue, down from 43% in Q3.

We’re very pleased with the growth in both AdSense for search and AdSense for content, as our search partners experienced strong 4th quarter performance and we continue to add publishers to our network, extending the reach of our advertising platform.

This quarter, revenue from international operations was $735 million, an increase of 18% over the prior quarter. International operations contributed 38% of total revenue compared to 39% in Q3 and 35% in Q4 of ’04. The UK contributed 14% of total revenues as compared to 15% of total revenues in the third quarter. The decrease in international revenue, in UK revenue as a percentage of total revenue, is attributable to foreign exchange and to seasonal trends, both of which I will explain further.

We experienced an unfavorable impact to revenues due to the strength of the dollar relative to foreign currencies, primarily the Euro, the Pound and the Yen. Had foreign exchange rates remained constant from Q3 through Q4, our revenues would have been $12 million or roughly .6% higher. Had foreign exchange rates remained constant from 2004 through 2005, our revenues would have been $40 million or 2.1% higher.

In addition, we saw stronger seasonal trends in the US than in the international business in Q4 with weaker December spending in certain verticals in the UK. Last year the effect of this trend was offset by favorable impact from foreign exchange and from the addition of AOL Europe in Q4 of 2004. We continue to see good progress in our international operations. Overall, our international business had a strong quarter, with very healthy growth in Europe, Asia, central and South America. We continue to see international expansion as a key area of opportunity and investment. We remain under-penetrated in several markets and are focusing our efforts on building out our infrastructure and bringing more localized products to these markets.

So in summary, we are very pleased with the strong revenue growth in the quarter and for the year.

Turning now to costs and expenses. As all of you know by now, at Google, cost of revenue is comprised mainly of traffic acquisition costs or TAC, expenses association with the operation of our data centers, credit card processing charges and amortized expenses associated with purchased and licensed technologies.

In the 4th quarter, cost of revenue increased to $775 million, up from $654 in the 3rd quarter, but decreased as a percentage of revenue to 40.4%, from 41.4% in the previous quarter, primarily due to a reduction in TAC as a percentage of revenue, which I’ll discuss next.

TAC, or the revenue share we pay to our partners, increased to $629 million in Q4, from $530 million in Q3. TAC as a percentage of advertising revenue decreased from 34% in Q3 of 2005 to 33% in Q4. This decrease is related primarily to revenue mix, as revenue from Google.com sites increased relative to revenue from the Google network.

In Q4 of 2005 R&D spending increased to $157 million from $152 million in Q3. R&D spending as a percentage of revenue declined to 8% from 10% in the prior quarter. The decrease in R&D as a percentage of revenues is due primarily to a reduction in IPR&D charges in connection with acquisitions, as well as with the seasonality of engineering hiring in the month of December. You should fully expect to see growth in this expense line as the pace of innovation at Google accelerates.

Turning to the sales and marketing front…sales and marketing in Q4 was up $155 million, an increase of 47% from $105 in Q3. As a percentage of revenue, sales and marketing increased from 7% in Q3 to 8% in Q4. This growth is attributed primarily to the development of global marketing programs such as our toolbar distribution deals, expansion of our global sales force and investments in Asia and Latin America.

G&A increase to $114 million in Q4 from $92 million in Q3, an increase of 23%. On a percentage of revenue bases, G&A stayed flat with the prior quarter at 5.9%.

Turning to stock-based compensation, stock-based comp charges grew in Q4 to $58 million from $46 million in the previous quarter, primarily related to Google stock units issued in Q4 and those that were issue previously. Our non-GAAP results are net of these charges, after the related tax effect. Stock based compensation in 2006 will be significantly greater than it was in 2005 as a result of our adoption of 123R, effective January 1, 2006, which requires the expensing of all stock-based compensation. We currently anticipate the dilution related to all equity grants will be in the 1-1.5% range in 2006.

As we discussed on our last call during the 4th quarter, we contribute $90 million to the Google Foundation. This was a non-recourse, non-refundable donation and was recorded as an expense in Q4. We do not expect to make further donations to the foundation for the foreseeable future. We do however expect to make equity and other investments in for-profit enterprises that aim to alleviate poverty, improve the environment and achieve other socially or economically progressive objectives. We expect these investments to be made primarily in cash and to be valued at approximately $175 million over the next 3 years.

Turning to operating margins, our non-GAAP operating margin in the 4th quarter was 37% of revenues; we’re down slightly from the prior quarter as revenue growth and a more favorable revenue mix were than offset by significant investments in all areas of our business. Our GAAP operating margin declined primarily as a result of a $90 million donation to the Google Foundation in Q4.

Now I’ll turn to taxes. Our effective tax rate for Q4 increased to 41.8% this quarter and to 31.6% for the year, above expectations of approximately 30% for the year. The amount of tax expense we recognized in any particular quarter is driven by our estimates for the year. And as we’ve said in the past, our estimates for the year are sensitive to the mix of earnings in the US and overseas. These estimates are complex and 2005 was the first year we realized any reduction to our effective tax rate as a result of profits earned overseas under our international structure. At the end of the year, we must true up the tax provision for the year, which could and in the case of Q4, did have a disproportionate impact on the 4th quarter. In calculating our true up for the year, the proportion of expenses allocated to international operations was greater than we expected. Primarily as a result of this a greater percentage of our profits were taxed at a higher domestic tax rate, which resulted in a greater effective tax rate, compared to our expectations. Keeping in mind the complexity of projecting tax rates, we expect our effective tax rate for 2006 to be approximately 30%.

Looking at liquidity, net cash provided by operating activities for Q4 totaled $658 million as compared to $647 for Q3. Free cash flow, another non-GAAP measure of liquidity, is defined as cash provided by operating activities, less capital expenditures. This quarter we generated $413 in free cash flow, as compared to $354 in Q2 and $309 in Q4 or ’04. Our capital expenditures in the quarter were $245 million, primarily reflecting purchases of servers and networking equipment as well as acquisitions of additional office space.

Adjusted EBITDA, defined as net income before interest, taxes, depreciation, amortization, IPR&D and stock-based compensation, increased 21% to $814 million or 43% of revenue in Q4, up from $672 million or 43% of revenue in Q3.

Our cash, cash equivalent and marketable securities balances were just over $8 billion at 12/31 of this past year, up from $7.6 billion at the end of last quarter. Days sales outstanding, or DSOs increased to 33 days from 31 days last quarter. This reflects the growth of our international business where credit terms tend to be longer as well as the extended credit to certain customers in the US.

Now, I’ll summarize our annual results.

Full year 2005 revenues increased 93% to $6.1 billion. International revenue accounted for 39% of total revenue, up from 34% in 2004. GAAP operating income was $2 billion, compared to 2004 GAAP operating income of $640 million, which was impacted by a charge related to a legal settlement in 2004.
On a GAAP basis, that income nearly quadrupled, reaching $1.5 billion, compared to $399 million in 2004.

Total Cap-ex spending for the year was $838 million.

Looking forward, we will continue to invest heavily in our global infrastructure, including servers, networking equipment, and data centers, with a smaller proportion on real estate investments. On a worldwide basis, we grew to 5,680 full-time employees as of December 31, 2005, as compared with 4,989 employees as of September 30, 2005 and 3,021 employees as of December 31, 2004.

So, to summarize, we are very pleased with our Q4 results. As we have previously emphasized, we are investing aggressively in our business and scaling rapidly to pursue enormous opportunities for long term growth. We will fuel innovation through deliberate and appropriate investments in R&D and in our core infrastructure as well as through acquisitions. We believe these investments are critical to achieving our mission and to maintaining our competitive advantage.

And with that, I would like to turn the call over to Larry Page for more details.

Larry Page, Founder and President, Products

Thank you George. We spend a lot of time at Google focusing on our users. We’re always finding new ways to serve their interests better. I want to talk about three areas where we’ve been targeting our innovation. We see the users want more personalized products that they can tailor to their needs. We see that they’re always looking to find more information easily. And we recognize that users are seeking new ways to get information using devices other than their PCs.

During this past quarter, we introduced several new products and services that we think will help meet these needs. On personalization, we’re learning that as people use Google more, they want more targeted results. So we’re bringing information to our users in more personalized ways. For example, our personalized search feature takes previous search history into account when presenting results and is now available in 12 languages. Users can set up Google News to get stories based on their preferences through the Google accounts login. We also launched 12 new local editions of Google News, expanding the reach of news information tailored to users.

More recently, we announced Google Personalized Home for mobile devices. A new service that enables users access to their personalized Google home page on their mobile phones and PDAs.

And just this week, we announced a beta version of Google Toolbar that offers the ability to store bookmarks and access them from anywhere and other new features.

To provide people with more information, we worked with more partners to add new content to our services. Google book search and a related library project, provide new ways for users to locate material that previously couldn’t be searched online. Google Base collects even more information about a wider diversity of new types of searchable content. The way we organize and present the content allows us to give users more targeted search results. We broadened the scope of Google Video so that users can search across the wide range of videos from many new content producers. We’ve already announced deals with CBS, the NBA, Charlie Rose and others, and expect to announce more in the coming quarter.

Finally, we are also giving our users more ways to access information. Last quarter, we released versions of both Gmail and Google Local for mobile devices. Anyone with a Gmail account can now easily get messages from their mobile phone. With Google Local now integrated with maps, users can access business listings, maps, driving directions and more on their mobile devices. RIM recently announced the release of Google Talk on their Blackberry hand held devices. We introduced Google personalized home for mobile, covering both seams that I discussed previously.

In addition, we signed agreements with Motorola and T-Mobile to provide search services to millions of mobile phone users. We believe that mobile applications are essential in bringing the internet experience to users in countries where mobile usage outpaces broadband.

Overall, we’re continuing to make progress towards our mission to organize the world’s information and to make it universally accessible and useful. Looking to 2006, we expect o launch more products that bring more information and more content to our users. Now I’ll turn the call over to Sergey.

Sergey Brin, Founder and President Technology

Thank you Larry. First I’d like to share some thoughts on our advertising business. At Google, we have built a user-centric business, meaning that ad-serving is based not only on when and where the advertiser wants an ad to be shown, but more importantly, when and where the user wants to receive the information. We have encouraged our advertisers to use an always-on approach to their campaigns, rather than a more traditional flight-based approach. And we are now really reaping the benefits of this approach.

Changes we have made within our sales organization are enabling us to address advertisers’ needs in a more targeted way. The 4th quarter was the first full quarter with a vertically organized sales force in addition to a growing inside sales channel. And, we have been reaching out to both Fortune 500 customers and medium-sized businesses more effectively. Larger companies are now including interactive advertising as significantly and increasing components of their overall marketing budgets. They are making more investments in technology and in partner relationships to help them to scale and to better measure ROI.

Ford Motor Company has successfully partner with Google to execute integrated lead-generation and branding campaigns for years. During the quarter, Ford was the first automotive advertiser to run a major placement within our site targeting program. This campaign generated awareness around the launch of the new Ford Explorer, as well as promoted Ford’s sponsorship of the Road to Kona Ironman competition.

Alongside our larger advertisers, we continue to see many smaller, less well-known advertisers building their businesses through AdWords, as we help them drive qualified leads to their site and grow into larger companies. Our platform creates a level playing field that allows small and medium businesses to take advantage of the same features, such as site-specific targeting, regional targeting and conversion tracking to ensure their message reaches their intended audience.

We are also providing more flexibility for all of our advertisers. During the quarter, we introduced AdSense on-site advertisers sign-up, where publishers can sign up new advertisers directly from their websites, and AdWords separate content bidding, which enables advertisers to place separate bids for ads that run on content sites, giving advertisers more choice and more control over their ad placement.

As always, we are focused on improving the quality of the ads that we serve and will continue to make product improvements that better match ads to queries and to content.

In Q4 we renewed several important AdSense partnerships including InfoSpace, Terra Networks and Span end result, Key Online and ECBig Globe, Business.com, WebMD and C-Net. We also signed new deals with PBS, Encyclopedia Britannica and Merriam Webster. And per our announcement in December, we have also extended our relationship with AOL.

We continue to develop innovative ways to extend our competencies to other media channels. In addition to our continued testing of outplacement and print publications, this month we entered into an agreement to acquire DMARC, a digital solutions provider connecting advertisers directly to radio stations, through an automated media platform. We plan to integrate our AdWords platform with the DMARC solution in order to provide another distribution channel for our advertisers and ultimately to increase overall spend with Google.

So, switching gears before wrapping up, I’d like to talk about some of the great progress we have made toward building out the business internationally.

In November, we opened offices in Brazil and Mexico and increased the size of sales and operations teams in regions where we still have large opportunities to increase our penetration such as in China, Japan and India. We continue to rollout localized versions of our products in new languages, which is essential if we are to meet the needs of different users and different markets. This quarter, we rolled-out sixteen languages for Google analytics, 12 languages for Google personalized home page and 15 languages for Google desktop, among many others. As we look forward, we will intensify our efforts to build out our infrastructure overseas and to develop products that are tailored to individual markets. We will continue to develop tools for our advertisers to help them better understand and improve their ROI. And ultimately, our goal is innovation. We hope to create new and better ways for advertisers to connect with their customers wherever they may be. Eric, over to you.

Eric Schmidt, Chief Executive Officer

Thanks very much Sergey. So we had a strong Q4, full of product enhancements, many partnerships, ongoing improvements to our platform and all very consistent with the relentless focus that we have on user experience and the integrity of our search results.

We see the revenue and profitability expectations of the quarter and we’re scaling this business rapidly and we’re investing for the long term. This is a distribution scale business of, in my opinion, enormous proportions focusing on end-users, billions of them. When we build a product we need to think in terms of the billions of users that are in so many different countries. We need to create access points for all devices so they can get this information and we’re focused on executing our business as scale with the lowest cost for capital and the highest performance delivered in the industry.

From my perspective, this remains a unique and historic opportunity. Putting more data on the server and information on every kind of device: mobile phones, moving information from personal computer to personal computer, personal computer to mobile, without having to figure out things like what files server, all of those kinds of things are something that people have been clamoring for for a long time. We’re not yet finished getting all the information into Google into the hands of end-users around the world.

So looking at 2006, lots of investment in better search tools, more personalization, much more content, a lot more focus on the advertisers. We’re already seeing strong monetization from our existing advertisers and many more advertisers are joining. We get feedback from our advertiser cycle. Feedback in the cycle causes us to provide better monetization per query, more services and more ways of making money as this market grows and as our reach grows.

We have more advertising clients with brands. And those advertising clients with brands are learning how to use our technology to solve their business problems. We’re also applying this to different mediums. Leveraging technology in other innovative ways; new user access points, mobile phones, consumer electronics, television, radio with the DMARC acquisition, print, click to call, all either launched or under development here at Google.

From a corporate perspective, we are growing our talented employee base. Great technical people, great business leaders all around the world. We’ve added Shirley Tillman and Anne Mather two outstanding individuals, to our board.

Google is still completely committed to the fundamental mission of getting all of the world’s information easily accessible and useful. We’re going to do very, very well here. So with that, we look very much forward to spending some more time with you at this year’s analyst day on March 2nd and Kim, is it time to go to question?

Yes, please.

Question-and-Answer-Session

Operator:

Thank you, if you’d like to ask a question, please press *1 on your telephone at this time. Again, that’s *1 if you’d like to ask a question. If you are using a speaker phone, please be sure that your mute function is turned off to allow that signal to reach our equipment.

We’ll take our first question from Yousef Squalie at Jeffries.

Yousef Squalie

Thank you very much, two quick questions. First, George, if I were to normalize for the differential in your tax rate, am I correct in basically seeing that there is a 24, 25 cent differential which basically puts you back at $1.78? And second, Sergey, what are your plans regarding the offering of rich media display formats to your network of publishers? Can you just talk about time-in? I understand you guys are doing a small beta right now. Should we expect revenue share to be similar to that of the Ad Network program?

Thanks a lot.

George Reyes, Chief Financial Officer

This is George, as you’re correctly starting to figure out here, really most of the mess was related to the tax impact and that’s sort of the gap to consensus. I think that’s the question you were asking.

Yousef Squalie

Correct, and Sergey?

Sergey Brin, Founder and President Technology

Yes, this is Sergey. We have increasingly offered more and different kinds of ways to put advertisements on line. We’ve been somewhat conservative. As you know it took us a while to allow image advertising within AdSense, but we allow it now. And we have now increased the number of different formats and sizes that we offer. I expect that we will continue to do so, but we will want to be cautious that the formats we allow have restrictions that mean that the websites that run AdSense always have a peaceful presentation. We wouldn’t want really outrageously flashy things to just distract everyone from the website and for that website as a result to not want to participate in AdSense. That said, we’re definitely open to lots of new great media formats from interactive and obviously the offline ones of print and radio that I already mentioned.

Operator: We’ll go next to Mark Mahaney at Citigroup

Mark Mahaney.

Thank you, two questions. As you lok at the other types of medium, print and radio, is it push or pull that’s taking you there? Do you have existing clients who are coming to you saying we’d love to see you come up with advertising solutions for those media or are those just areas you find interesting in the meat of innovation? And just real quickly, any more color on the UK vertical weakness you mentioned George?

Thank you.

George Reyes, Chief Financial Officer

Why don’t we add Omid and Jonathan to the conversation since they’re on the line. Omid, do you want to start with advertising?

Omid Kordestani Senior Vice President, global sales and business development

Sure, thanks, yes. I think it’s really a combination. We’re really trying to figure out how to reintegrate the advertising solutions with more of the successful model we have of measurability. For example, we’re very impressed by DMARC and the solutions they’ve provided already with the bringing of a level of automation that is very similar to our model. Now, the ROI models are going to be very different and we’re going to look for working with our existing customer bases to expand into these new formats and mediums. The other is really, frankly, again as I mentioned we’ve organized our sales organization to be really much more focused industry by industry and figure out how, again, to best serve the needs of the Fortune companies, the major accounts and what we’re finding is that all of them have a lot of interest in figuring out how to bring more measurability and how to expand and integrate more solutions across different formats.

Jonathan Rosenberg, Vice President, Product Management

Hi Mark, this is Jonathan. Just building on Omid’s answer real quickly and I’ll cover the UK, I think that it really is our ability to offer a unified platform for all media to our advertisers and extend the accountability of online to other media that you’re really going to see. So it is both a push and a pull model, but it’s really getting to that more unified platform that I think is critical.

The UK answer is a little bit nuanced. You tend to see monetization in the UK is doing fabulously well, overall. We tend to see a little bit of the reverse kind of seasonality in the UK relative to the United States, over the holidays. There are also some specific issues just related to how the calendar worked and number of relatively high monetization days that slightly adversely impacted that. But it’s mostly just the reverse Christmas trend that you see in the UK, which is simply a cultural and vacation-related issue.

Operator: our next question comes from Douglas Enmuth at Lehman Brothers.

Douglas Enmuth

Thank you. I was hoping you could drill down a little bit more on the sales and marketing line which came in certainly higher than we were expecting. You talked about obviously growing out the sales force. Can you sort of give us some guidance in terms of how far along you are in this process in building up the sales force and also how much of a factor that was versus some of the other things you mentioned around toolbar distribution and expansion in Asia and Latin America? Thank you.

George Reyes, Chief Financial Officer

Hi, this is George Reyes. So, I think the best way to address this question is, over the course of the last year and all of these earnings calls that we’ve had, I think we’ve made it very clear that we are focused on growing our business and international expansion, in particular. So I think the way you should look at the increase in the sales and marketing line is just as a logical extension of that. We think the opportunity ahead of us, particularly in international markets I just exceptional and what you’re seeing is the investments that need to be made to sort of harvest that opportunity.

Operator: Our next question comes from Jordan Rohan at RBC Capital Markets.

Jordan Rohan

Thanks. I’m curious and maybe this ties into Doug’s question a little bit as well, as you look forward in 2006, do you see the same kind of incremental growth in operating expenditure? I think in the quarter you did $75 million higher operating expenditure than you did in 3Q. Is that the type of pace or growth in total operating expenditure that you can envision?

George Reyes, Chief Financial Officer

Yes. As you guys know by now we don’t give explicit guidance, but let me try and sort of replay my tape one more time. So we think the opportunity ahead of us, especially in international markets, is exceptional. So we’re going to continue to invest at these rates. And that’s sort of the agenda here.

Operator: Our next question comes from Scott Kessler at Standard and Poor’s

Scott Kessler

Thanks very much. The growth in the Google network websites was a little bit lower on a relative basis than I had expected, and I was wondering if you could provide any details related to that? Thanks a lot.

Omid Kordestani Senior Vice President, global sales and business development

Hi, this is Omid. We actually have had very good success in renewing contracts and signing new ones as Sergey mentioned. It just has to do with the fact that some of the biggest partnerships are in long term contracts with us and that there weren’t any really new significant, major amounts of traffic both in terms of content or search that we added to the network. From their end, we’re experiencing nice growth in traffic, seasonality was nice in the commerce sector and we also are continuing to focus on partnering.

Scott Kessler

Are a number of these contracts that you speak of up for consideration in 2006? Is the pipeline looking like you want it to look like? I think people are kind of wondering why the revenues were the way they were for that particular area.

Eric Schmidt, Chief Executive Officer

This is Eric. In general, the contracts are multi-year contracts and so they’re pretty locked in from a business model perspective. The benefits that we offer advertisers for improved RPM, that is literally revenue growth per query per advertiser, and so forth, are new to both Google.com and the partner network. So what you’re really seeing is that the aggregate growth of the partner network is growing somewhat slower than the total growth of Google.com, which is also mirrored in some of the market share analysis that people are showing. And, it’s hard for us to predict whether that will continue, but it has been a trend for some time. We are reasonably indifferent to which category gets the growth, although if Google.com grows, there’s more of a private contribution, because we keep 100% of that rather than doing a rev share with the partners in the TAC relation.

Operator: We’ll take our next question from Mark May at Needham and Company.

Mark May

Thanks for taking my question. It has to do with new consumer products. Some of the new products that you launched last year have received mixed reviews. For instance, Google video. I’m wondering if you could sort of grade yourself in terms of how well you think those initial launches were; if it were less than a 10 or a 9, what might you do different to improve the user experience there? And then just secondly, we haven’t heard much about Founder Awards in a few quarters. I’m wondering do you have any updates? Recent awards? Or is that a reflection of innovation within the company? Thanks.

Eric Schmidt, Chief Executive Officer

Maybe we could have a founders comment on that then Jonathan add as well. I was going to comment that we tend to ship products very early and in Beta, precisely so that we can experiment with them. Larry or Sergey?

Larry Page, Founder and President, Products

We have always done that. In fact we launched AdWords like that and it took us a while to get to the model that we have now. We actually had…we didn’t have pay-per-click initially. This is sort of how Google has always worked in that we love getting things out really early, we love experimenting with them, we love having a huge pace of innovation. And so I’m actually very, very happy with our process. We’re launching a lot of different things that people are really interested in. The teams that are doing those are learning a tremendous amount. Video has actually gone through three iterations already. And, it has been tremendously successful. We’ve gotten huge numbers of videos on there. We just recently launched the paid videos and we expect to do a lot more along those lines. And I couldn’t be happier with our progress there. Sergey will talk a little bit about Founders Awards.

Sergey Brin, Founder and President Technology

Yeah, this is Sergey. If you think over the past year, we’ve certainly had a number of very exciting, successful products that we are already pleased with and that have already repped great rewards for our company. It takes a little while, sometimes, to really assess that value and be able to appropriately reward those employees. But we do have one cycle of founders awards; it should happen in the next few weeks. There have just been a number of other important things we’ve had to attend to that have probably delayed that a bit more than we should have. And, we look forward to really giving those out because I think that I’m not going to pre-announce them now on the earnings call, but I think they’re well-deserved and most people will be very happy. With regard to some of the less mature products, I think we’re going to give them some time to see where they take us and really evaluate their overall benefits to Google as a company and to our end users.

Operator: Our next question comes from Heath Terry at Credit Suisse.

Heath Terry

Thank you. I was wondering if you could talk a little bit about gmail. Specifically, what kind of traction you’re seeing there both in end users as well as monetization and what you think as that product starts to mature, how you think on a relative basis monetization within that offering will look versus the monetization in your core search business.

Sergey Brin, Founder and President Technology

This is Sergey. We are still in the phase of gmail where we are focusing on innovating on the features, the experience. We are spending an increasing proportion, but still a relatively small proportion of our engineering resources, focusing on the monetization. We are relatively comfortable that over time, once we decide to make that push, much as we did in search only after a couple of years of focusing almost exclusively only on the search experience. We are comfortable that that’s a very valuable service and will have some significant financial benefits.

Jonathan Rosenberg, Vice President, Product Management

Hi, this is Jonathan, just building on what Sergey said. We measure user satisfaction very, very carefully. So that’s one set of feedback which we get. We also did extend the signups to several additional countries. I think there were 8 or 9 countries that we extended to in December. And we also launched some new features towards the end of Q4. We added some simply things that people had been asking for in the satisfaction studies, just vacation auto-responder and RSS speeds and contact groups and viewing as HTML. So we made a lot of improvements in mail and in other media forms. But over time I think what you’re going to see is that we’re going to have different inputs into the out systems that are better and more appropriately tailored for the different product set. And gmail will certainly benefit from that as we crack the monetization code there.

Operator: Our next question comes from Troy Maston at William Blair and Company.

Troy Maston

Thank you. Question along the lines of the international business. You referred to it as under penetrated. I’m curious if you were referring to market share or penetration of search on the internet or monetization or perhaps all of the above? If it is monetization, can you give perspective on how effective you view your monetization in the non-US markets versus the US markets?

Eric Schmidt, Chief Executive Officer

This is Eric. Maybe Omid and I can answer that together. I said it because when I look at where those markets are compared to the US, I see them a couple of years behind the level of penetration and monetization in the US. In some cases, it’s simply because advertising online is new. In some cases, it’s because we were later on a relative basis of entering the market. And in some cases, it’s because e-commerce is still a new and fast-growing thing. If you look at the difference between the United States and Western Europe, for example, it took a couple of years for the model in the US to really take off in Western Europe. Our Western European revenue growth in the last year has been nothing short of amazing. And in fact, it looks like international growth, ignoring quarterly fluctuations, will continue to outpace US growth for the foreseeable future. So, we have made a decision to invest in many of the international markets to bring them up to the scale of the more mature markets of the United States and Western Europe. Omid?

Omid Kordestani Senior Vice President, global sales and business development

Thank you Eric. Yes, as Eric mentioned, this is a big focus for us and it was highlighted by several operations that got established last quarter from Brazil to Mexico, Poland, Israel, the European regions and Turkey. And I think the good news for the sector is that what we’re seeing is that our ROI based measurable form of advertising is really working everywhere with similar levels of interest. It’s just the maturity levels. So, even in a market like Japan, for example, that is pretty well established, the level of targeting and direct work with the clients is not at the level of sophistication that we see here in the States or the Western Europe. So we’re very busy taking the learnings and the best practices from the US and extending it where it makes sense. And then establishing our operations so that we can be on the ground and localize the products properly, localize our operations and attract talent from both a technical standpoint and business operations.

Operator: Our next question is from Lauren Fein at Merrill Lynch.

Lauren Fein

Thank you. Just a couple of quick ones please. I’m just wondering if you could update us in any fashion on how the AOL relationship is going in terms of just putting your heads together and figuring out how you’re going to leverage the content and your ad sales force. And then secondly if you can give us any quantitative update on how you’re doing in penetrating the Fortune 500. It seems like you’ve had some more visible success and with the vertical channels selling, it would seem that that would have helped as well. And for any quantitative or qualitative update there would be great.

Eric Schmidt, Chief Executive Officer

I think Omid and I will answer this as well. This is Eric again. On the Time Warner/AOL deal, we were very, very excited to announce a five year plus extension to that. It’s a very deep partnership involving quite a bit of video and other kinds of display advertising as well as much more integration with the sales force. That deal is signed and we’re busy planning all sorts of collaborations between the two companies. What I like about it is that it’s an extension of what we’re doing already, so there’s no hiccup, no negative, no hurt. Because of timing we were able to take advantage of it. So there’s a new set of products flowing through. We’re spending a lot more time with the sales force training them on the new technologies and we’re beginning to plan for some of the new display and video collaborations that we contemplated in our deal. Omid?

Omid Kordestani Senior Vice President, global sales and business development

Thanks Eric. We’re really focusing the organization to monetize the business at many levels. We’re offering the Fortune 5000 companies the ways to customize site targeting, for a really good examples of those you may have heard about were advertising in the entertainment industry like Paramount, very successful in using site-targeting to drive awareness of their movies before a movie launch. Drive sales of DVDs once it’s released Chrysler, Honda, StarCom, MediaVest have been also some of the other major users of site-targeting. So what we’re really doing is trying to again understand best how the Fortune companies are trying to work with us and share with them industry-specific, vertical specific knowledge of performance and really use all the tools and all the products we have available today and the new ones that we’re bringing forth to just improve their experience and bring measurability and reach of greater audience. And, we’re very pleased with our progress.

Operator: We’ll take our next question from Anthony Noto at Goldman Sachs.

Anthony Noto

Thank you very much. I wanted to focus on three areas that I think you’re generating very little revenue from if not any at all. Specifically, Google images, Google local and then Google China. I think the last time we touched base you were generating zero revenue in Google China, is that still the case? Second part of the question, Google images, I believe you’re not generating any revenue from. It’s a sizeable vertical with 25 million unique visitors according to Media Metrix. What’s the methodology and when do you think you will monetize that and what are some of the considerations for getting factors? And lastly, Google local, there seems to be a lot of innovation going on in Google local and click to call would be a great way to monetize that. If you could comment, thanks.

Jonathan Rosenberg, Vice President, Product Management

This is Jonathan. We’ve certainly done some experiments that you may have seen with images and it certainly is an area where we have significant traffic. What we typically see there is that people who go to images are looking for just that, they’re looking for an image. So, one of the things that we’re still trying to crack the code on there is what is the right context sensitive ads to offer? Certainly you can sell them images, but Google already supplies a reasonable number of images that are free. So, although we have a lot of traffic there, it has not yet proven itself to be one of the more monetizable vehicles, although there are certainly experiments that we’re going to continue on there. As far as the question related to China, I don’t know the specific answer on that. Omid may well know the answer on that.

Omid Kordestani Senior Vice President, global sales and business development

Hi, yes. China, we actually have both the online availability, the advertising available so that customers can come through the online channel and we’re very actively building our direct capabilities there. One of the things that’s important, obviously, is having all the right infrastructure on licensing available for us to be able to operate locally. So we’ve been very focused on just establishing ourselves. We’ve had great success actually in signing up resellers and the results from working with these resale appointments have been excellent, actually, in terms of a number of advertisers have actually joined our online program. And we’re looking forward to establishing direct relationships with both agencies and clients directly as our capabilities are getting built up.

Jonathan Rosenberg, Vice President, Product Management

And I’m sorry, I don’t think I answered your question on click to call, I mean, that’s obviously an exciting area and I think as we mentioned on the call last time, we’re testing the ability for users to speak directly to advertisers when they find them on a Google search results page. It’s free, they do it over the phone, they don’t have to dial an 800 number, we keep the number private and you know, what’s obviously exciting there is that you’re connecting somebody expeditiously and directly to a place where they’re reasonably likely to consummate a transaction. Whether it be a restaurant or an organization or a store. So, the monetization opportunity is obviously very significant.

Omid Kordestani Senior Vice President, global sales and business development

And to add to that on just the local front, as you mentioned, we believe that local is a very great opportunity. And, I think we’re going to…we have been experimenting, we’ll continue to experiment. We don’t want to rush to have the wrong advertising solution. But, we believe it’s such a fantastic opportunity that we’re investing a lot of effort to do it.

Eric Schmidt, Chief Executive Officer

Let’s take a couple of more questions.

Operator: Our next question comes from Robert Peck at Bear Sterns.

Robert Peck

Yeah, I just have two quick questions. One is, could you comment a little bit more on DMARC? And besides all the radio opportunity there, are there other opportunities that it provides, such as TV, video advertisement placement, pod casting advertising, etcetera. What opportunities does that technology provide? And number two, how should investors think about Google as a software and a hardware company? When we think about, particularly these transportable data centers, when we think about devices in the home, dub them Google Cubes or what have you, or even I believe the Linux system of Ubunto, how should we think about where Google’s going next and the opportunities in front of it?

Jonathan Rosenberg, Vice President, Product Management

I wanted to talk about DMARC, I don’t know about the second question. On DMARC, it is a very exciting opportunity. It took us a while to figure out that there was this possibility of the radio market, based on its structure, based on its technology, based on the existence of a company such as DMARC. And, we are, as you know, experimenting with print. We don’t know exactly how it will work. We are optimistic. I suspect that advertisers want greater access, better accountability, more unified framework for their ROI and so forth, I suspect there’s great demand for all those things. And, as a greater consequence, we can generate greater revenue for the publishers. But, this really requires a lot of testing and development and understanding of this specific market. So I can’t forecast the success of any of those but I have great optimism.

Eric Schmidt, Chief Executive Officer

I would add on the DMARC side that this space is a vast space and so this acquisition lets us go in there with a very, very differentiated product and tied to our advertising system, should provide a significant growth in scale, globally. On your question about sort of hardware and software company aspects, you mentioned Ubunto, which is a Linux brand, we use it internally but we have no plans to distribute it outside of the company. There’s an awful lot of speculation about Google playing in those markets. The Google PC, those kinds of things. To me, most of those are people projecting the last one, not the next opportunity on us. And from my perspective, those are not very interesting business opportunities; they’re well covered in the market, we partner with many of the players and we would much prefer to deepen our partnership with them than to go into competition with them.

We are relentlessly focused on this new end-user experience, which is multi-platform and based on the internet and that’s where our future is. That’s where the growth is, that’s where the revenue and monetization is. And, as I mentioned earlier, it’s so large, it makes no sense to divert our resources to these other and somewhat smaller opportunities.

Operator: The final question comes from Trina Choudry at JMP Securities. Miss Choudry, please go ahead. I’m hearing no response, would you like to take another question?

Yes, of course.

Operator: We’ll take our final question from Mary Meeker at Morgan Stanley.

Mary Meeker

Thank you. If we compare the 3rd quarter sequential results with the 4th quarter results, I think you said on your last call your query growth was kind of flatish, I don’t want to put words in your mouth, so please correct me if need be. And the revenue growth was pretty powerful so the monetization increase sequentially in the September quarter was very high. In this quarter, you in your press release and on the call you talked about seasonal strength in traffic and also in monetization. Could you give us a little more color on the differences in the degree of incremental monetization you had in the 4th quarter versus the degree of incremental positive monetization you had in the 3rd quarter? Thanks.

Eric Schmidt, Chief Executive Officer

This is Eric. We saw both strong user traffic in the December quarter as well as continued improvement in the monetization. I wouldn’t characterize them as being on the monetization side as being materially different than the rate of improvement that we saw in Q3. We are continuing to invest heavily in improvements in quality; those improvements in quality and many other enhancements that we offered in our product line, result in continuous improvement every quarter in monetization on a constant flow of traffic. In addition to that, traffic grew quite strongly, perhaps because of seasonality, perhaps because of gains in market share, perhaps because of all the new products, or perhaps because of a combination of all three. But we know that both are working and when both are working well, we see very, very strong resonant growth, which is of course wonderful.

What I’d like to do now since we’re run out of time is go ahead and wrap up by saying that to all of you first, thank you for taking the time to be on the call. We’re very, very pleased with our performance on every level. The financial, the pace of innovation, the growth, the quality of the leadership in the company, the positioning that we’re in today. This is a very exciting industry to be in and it’s getting increasingly more interesting every day. We’re very…we’re still very much in the early stages. I think in my view, making tremendous progress of realizing the long term vision that we’ve outlined over the last year or so, with you to organize the world’s information. And we’re tirelessly committed to delivering this value to our users and to our shareholders. We are innovating at scale and we’re seeing strong user growth and strong revenue growth. And again, you see that in our numbers, you see that in our comments. Life online through Google, information plus search plus advertising, making all of that seamless, is not just the Holy Grail for the company but it also provides tremendous operating efficiencies, revenue growth, and we believe all told very strong cash flow and profit growth. As an example, very, very large advertisers now see the ability to take large sets of businesses that they have and spread them across a pretty wide variety of products offered in many different markets through Google. The multiplicative effect, which you get by strong revenue growth, strong user growth, strong product line growth and many new advertisers is what is going to, currently we believe, continue to deliver very, very strong growth here in the company.

So thank you very much again to our users, our partners all of our employees, our shareholders. I’m very, very sure 2006 is going to be an exciting year for Google. So with that, thank you very much.

Operator: Again, this does conclude today’s conference. We thank you for your participation. You may disconnect at this time.

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Source: Google Q4 2005 Earnings Call Transcript
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