Google's Q4 Earnings: The Evidence So Far (GOOG)

| About: Alphabet Inc. (GOOG)
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Mark Mahaney Smith Barney CitigroupGoogle reports its results for Q4 today (Tuesday 31st), after the market closes. Citigroup analyst Mark Mahaney has done an outstanding job collecting together the evidence so far about Google's Q4 earnings. Extract from his January 26th note to clients:

1. Yahoo! Read-Thru For GOOG: Neutral -- On January 17th, Yahoo! reported a Miss & Lower quarter, with notable weakness in its Search (particularly, International Search) results. Specifically, Yahoo!’s reported International TAC (Traffic Acquisition Costs) rose a very weak 3.7% Q/Q. Our initial read-thru was that the likely culprits were the possible loss of small affiliates, weak performance at Yahoo! Japan, market share losses in Europe, and FX headwinds. We actually viewed Yahoo!s U.S. Q/Q TAC growth of 13.1% as relatively robust, and thus a positive read-thru for Google. But the international weakness at least raised questions and made the overall read-thru neutral to slightly negative. Based upon a final scrubbing of the data, we concluded that Yahoo!’s Owned & Operated (O&O) search revenue grew approximately 12% Q/Q in December. We view this as a relatively healthy growth rate, although it does mark a material deceleration from approximately 18% in December 2004. What are the implications for Google? Given the differential between their Q/Q O&O growth rates over the past several quarters, we believe that the Yahoo! O&O results reinforce our 25% Q/Q assumption for Google’s December quarter.

2. Yahoo! Japan Read-Thru For GOOG: Neutral
– On January 23rd, Yahoo! Japan reported its December quarter results. (Yahoo! owns a 34% stake in Yahoo! Japan and provides paid search services to it.) One of the key takeaways from the Yahoo! Japan results was the relative weakness in its search revenue. Based on company disclosures, we estimate that search grew less than 9% Q/Q for Yahoo! Japan, materially below its 15% Q/Q advertising revenue growth. Further, adjusting for the $/Yen currency shifts, Yahoo! Japan’s search revenue grew only 3% Q/Q. These points matter because they help to explain the weakness in Yahoo!’s international TAC growth. Per our analysis above, Yahoo! Japan accounts for 33% of Japan’s International TAC. And with weak performance in this segment – which was likely caused by a change in search icons – compounded by FX headwinds, Yahoo!’s international TAC growth in December faced a very heavy drag. What are the implications for Google? Given that Yahoo!s international search weakness was company specific (Yahoo! Japan and the Yen), it appears that there was no broad international search weakness in the December quarter facing Google.

3. eBay Read-Thru For GOOG: Positive
– On January 18th, eBay reported its December quarter results. As one of the largest buyers of search advertising and very likely one of Google’s top customers, eBay’s results matter. Signs that eBay is cutting back on marketing spend and search advertising is a negative for Google. Signs of increased marketing spend and search advertising a positive. What were the numbers? In the December quarter, eBay spent $370MM on Sales & Marketing, an amount that was up 38% Y/Y and 26% Q/Q. While eBay doesn’t disclose its specific search advertising spend, we believe that search’s share of eBay’s marketing budget has moderately increased over the past year, particularly in several international markets. We also note that eBay’s segment generated a very material revenue growth acceleration in the December quarter – from approximately 30% Y/Y growth in September to 50% Y/Y growth in December. And we believe that a significant amount of this revenue growth was due to aggressive search marketing. What are the implications for Google? Given, that one of the largest search marketing buyers likely was a strong spender in the December quarter, that should bode well for Google.

4. MSFT Read-Thru For GOOG: Positive
– On January 26th, Microsoft reported its December quarter results. Peeling through the details, MSN’s advertising revenue grew 12% Y/Y, a material slowdown from the 22% and 20% Y/Y growth rates of the past two quarters. Further, MSN disclosed that its display advertising grew more than 20% Y/Y, implying that its search advertising revenue growth may have been relatively very weak. This was largely acknowledged by MSFT during its conference call. And the company also indicated that search and its Ad Center solution would be a major investment priority for MSFT in 2006. What are the implications for Google? Almost certainly, the December quarter will mark a time of MATERIAL market share gains by Google in the U.S. search market. And this is a fundamental positive for GOOG. Indirectly, we also view the MSN performance and announced investments as a sign of the strong competitive moats Google has built up around its business. By our count, Google’s total R&D and capex spend between 2004 and 2007 will tally at least $6B. That’s a substantial amount of resources for any company, including Microsoft, to shell out. On a broader level, we detail below Internet advertising revenue trends for the Big Four Net Properties – Yahoo!, MSN, AOL TimeWarner, and Google. With Yahoo! and MSN now having reported 2005 and with Google and AOL on deck, it looks very likely that 2005 will market a time of MATERIAL market share gains by Google in the global Internet advertising market. Separately, we see that Microsoft is opening two research labs focused on Internet technologies, principally search. One of the labs is being headed by leading search expert Gary Flake. We view this development as further demonstrating the significant commitment Microsoft is making to competing with Google in search. We continue to view Microsoft and Yahoo! as material competitive risks for Google.

5. Third Party Data Read-Thru’s For GOOG: Mostly Positive – Although we lean more heavily on P&L results than on third party data, we do focus on select search query, clickthru, and pricing databases. Per comScore, Google’s Q/Q growth in paid search clicks was 14% across its network of U.S. sites (O&O and affiliates) and 22% on its ownWeb Sites in the December quarter. Compared to the results tracked for Yahoo!, MSN Search, AOL Time Warner, and Ask Jeeves, these are very strong results. At the extreme – in what is a hard-tobelieve number – MSN Search’s paid clicks declined 22% Q/Q, while Yahoo!’sWeb Site clicks grew only 3.5% Q/Q. What are the implications for Google? If the U.S. paid search click trends are accurate, this quarter marked a MATERIAL U.S. market share shift towards Google. This is nothing but a positive for Google.

Switching over to the international market data, the third party data read-thru for GOOG also look positive. Per comScore again, Google’s share of non-U.S. search queries has steadily increased over the past five months from 68% to a record high 71%, while both Yahoo! and MSN’s share has slipped. What are the implications for Google? If the international search query trends are accurate, this quarter marked a MATERIAL international market share shift towards Google. Again, a fundamental positive for Google. Finally, we present the bad news. Or at least, what could be the bad news. Below, we exhibit recent keyword pricing trends as compiled by Fathom Online. We’ve always been cautious about this data, but we highlight it here to cover the bases. Clearly, pricing is a key driver of search revenue. Tracking it is crucial. But tracking it effectively – given that perhaps as many of 20MM search terms are being bid for at any one time – is a daunting task. What the Fathom data indicates is that average keyword pricing is down 12% Y/Y and 5% Q/Q. If true, this could pose risk to some of the high expectations out there for Google’s December quarter. Our bias is to focus on broader buyer trends – the increasing number of advertisers using search marketing, the increasing share of advertising budgets that are being allocated to search marketing, and the increasing share of search marketing dollars that are flowing to Google. We believe all of these trends are positive and strong for Google. And that’s a major reason we have a Buy on these shares.

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