Google's Escalating Costs A Cause For Concern

| About: Alphabet, Inc. (GOOG)
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Investopedia Advisor submits: Google (NASDAQ:GOOG) has certainly done nicely for its shareholders in the past – but not this year. Since January, the search engine wunderkind’s shares are down by nearly 9%. Despite Q2 results that saw EPS grow 83% from last year's level to $2.49 and revenue rise 77% to $2.46 billion, the shares barely budged.

So, what’s holding Google down? Underneath the rosy earnings and revenue numbers is the specter of escalating costs. With Google spending more on capex than even the most pessimistic of us had expected, the stock has lost much of its luster.

Last year Google produced about $2 billion in free cash flow. Wall Street analysts reckoned that number could jump to $3 billion in 2006, lending some support to lofty discounted cash flow valuations.

But look what’s happened. As Google pours money into servers, network infrastructure, data centers and office space while it rushes to staff up, free cash flow has plunged. In Q2, Google produced just $142 million in free cash flow.

To put things in perspective, capital expenditures grew by 344% year-over-year and by 103% quarter-over-quarter. Capex is growing faster than sales.

Meanwhile, in Q2 marketing costs jumped 88% to $196 million from the same period last year and R&D costs more than doubled to $283 million.

At this rate, Google’s on track to generate for 2006 about $2 billion in free cash flow - the same amount produced last year, and nowhere near the $3 billion investors were looking for.

Granted, some of the capex represents one-off spending. For instance, $315 million went towards a California real estate purchase. Nevertheless, investors should be wary of what is starting to look like higher-cost business model.

Thanks in large part to a few well-timed share issues, Google now sits on a war chest of nearly $10 billion in cash. It may well need it. To hold its lead against the likes of Yahoo! (YHOO) and eBay (NASDAQ:EBAY), Google has to keep on spending. Also, fending off Microsoft’s (NASDAQ:MSFT) forays into the Internet arena will demand even more spending.

Sustained market dominance won’t come as cheap for Google as it has in the past. The result could be a painful share price correction as investors take a harder look at what the internet giant is actually worth.

GOOG 1-year chart:

By Ben McClure, Contributor - Investopedia Advisor

At the time of release Ben McClure did not own any shares in any of the companies mentioned in this article.