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What a difference a week makes - last week, markets reacted negatively to Google's (GOOG) bungled earnings release. While the report did show some softness in the company's operations this quarter, the broader headline was that a vendor for one of the world's largest information security companies prematurely released sensitive market information. Yikes! But, distractions aside, the quarter was not as bad as some feared. In fact, we at Gestalt Investors feel the long-term story for Google remains bright.

For Earnings Reports, Context Matters

The rapid intra-day price decline reinforced the conventional notion that firms should announce earnings while the market is closed. Releasing after the close affords market participants the opportunity to digest the release, ask management questions, and update their models. This approach often leads to a more thoughtful market response. When released intraday, the frenzy in the market does not afford either traders or buyside investors the luxury of processing a nuanced report such as this. The result is that traders with tight risk limits will likely first reduce risk by selling or trimming the position, and only then ask questions. We get the sense Google will be extra careful to time the release appropriately going forward.

Given the surprise nature of the report in both timing and substance, it is not surprising the stock sold off. But stepping back, the Q3 2012 conference call added several promising, incremental data points:

  1. Average cost-per-click (CPC) indeed declined by 15%, but context matters -- more than half of that decline (8%) was due to currency effects. We can strip that out because it is a mark-to-market accounting thing- GOOG will not repatriate the money.
  2. Aggregate paid click traffic increased by 33%
  3. Google is working on promising extensions to their search dominance: location-based mobile ads and Google Now

Taken together, we think the data points do not support the market's narrative that Google is struggling with its migration to mobile. That narrative would have more credence had Google's paid click traffic in mobile declined substantially - that would be a direct sign of troubles in the transition. For example, users are more likely to search for low CPC items, such as a grocery chain, on their smartphones and higher CPC items, such as a mortgage, at home. As users migrate from their PCs to tablets, they will do conduct all their search on mobile devices. So the decline in CPC, by itself, does not necessarily signal trouble in mobile. If fewer people were to click on ads on mobile, that would spell trouble. As the datapoints above indicate, that is not the case here.

Mobile Opportunity: Goodbye search box, hello Google Now

Mobile, as with any platform transition, presents both risks and opportunity. For Google specifically, we see more opportunities than risks, as it is uniquely positioned to capitalize on certain opportunities.

Many investors are concerned about Google's ability to seize the mobile transformation, chiefly because they assume Google's mobile user interface will remain as it currently stands: the clean search box with advertising sidebars. Much has been made about the limited screen space available for such sidebars on mobile devices. Therefore, many investors wonder, how can Google's advertising-driven business model work on a space-constrained mobile device?

Well, as the tech community has learned over the years, Google is pretty innovative, able to adapt to an evolved design criteria. While a smartphone has the constraint of a smaller screen, the device also provides the additional functionality of GPS, video, and other features that can be integrated into a richer advertising experience. Google's upcoming location-based ad technology integrates its deep organizational knowledge honed from Google Maps, Google Offers, and Google Search to assist advertisers to convert nearby customers. You may have used the precursor to the technology if you have ever searched for "restaurants near me" or "gas near me" on Google. As Google's Chief Business Officer explained in the Q3 2012 conference call:

"We've intensified trading for our sales team across the globe, integrated sales tools, so we can really bring our customers' mobile video, Search, Display as a cohesive solution… As we help marketers reach consumers closer to the point of purchase, the opportunities will only get bigger.

We're already seeing glimpses of this. Take T-Mobile, who use location based mobile ads to drive people nearby into their stores, and in their words, win the last 10 feet. They achieved a click-through rate of about 13%, in what is a very successful strategy. These rates are 3 to 4 times of what you would see without using some of these context."

Bottom-line, advertisers are likely to stick with Google if they can maintain mobile click-through and conversion rates that are comparable to the desktop rates. Better yet, an advertising platform that allows marketers to "win the last 10 feet" will further drive CPC north.

We believe investors do not currently appreciate that mobile brings more opportunities to monetize Google's search product in ways that are not possible with a desktop or laptop-based search.

Soon, Google will provide customers with personalized coupons from stores while they are nearby. If the conversion rates from this program are high, the CPC will rise. The ability to leverage its deep organizational knowledge in search and its massive data trove of personal information gives Google a leg-up in developing marketing programs such as location-based ads.

Conclusion

We believe it is premature to conclude that Google's is stumbling with secular migration from desktops to tablets. Far from it. In our opinion, Google has the right initiatives to prosper in the mobile markets.

At the same time, we at Gestalt Investors do not view Google -or any investment-- as a one-quarter story. While it will take a few quarters for the mobile investments to bear fruit, Google is well-positioned to capture a substantial share of mobile ad spend.

Source: Google: With The Dust Settled, Mobile Looks Promising