Google Gets Gutted on Earnings

Google (Nasdaq: GOOG) shares, always a tricky trade going into earnings season because of the company's policy of not giving earnings guidance, today fell eight percent following an earnings statement that did not live up to expectations.

First off, let's be clear -- Google isn't going bankrupt or anything. The company still mints money. It had net income of $2.71 billion for the quarter, or $8.22 per share. That compared with $2.54 billion a year ago, revenue was $8.1 billion, which fell short of analyst expectations of $8.4 billion.

So why the freakout? The stock was down $54 per share to $586 -- or 8.4% -- in midday trading. Clearly the analysts, investors, and the market expected more for the company. And after a recent share run-up, optimistic expectations had been baked into the shares. The revenue shortfall was the primary concern.

Several business issues likely jumped out at investors, other than the fact that the company didn't grow revenue as fast as expected: The average cost-per-click (CPC), or amount Google charges for online text ads in search, dropped. In addition, expenses climbed from 30% of revenue a year ago to 32%.

So, Google's growth is not living up to expectations, and its margins are coming down. On the bright side, the company points to its display-ad business, which it has built up through acquisitions. CEO Larry Page said display ads are now on track for $5 billion in annual revenue. Growth in that segment is exceeding expectations.

On the company conference call, Google executives pointed to a few other issues dragging down earnings: Foreign-exchange rates were a drag on earnings, as were mobile results. Mobile search has a smaller profit margin than Google's traditional search and display ad businesses.

Don't forget that Google plans to buy Motorola Mobility in a $12.5 billion deal, a risky bet that is sure to mix up the business because it means Google is moving more heavily into hardware and the less profitable mobile world.

In the Q&A session, Google was questioned about the fact that cost-per-click (CPC) was down 8% overall, which may have set off alarm bells for some.

Google Senior Vice President Susan D. Wojcicki explained the two biggest factors in the decline in CPC were foreign exchange rates as well as changes in the mix of ad formats and partners. According to Google executives, changes in foreign exchange rates may have cost the company as much as $240 million.

On the bright side, analysts were intrigued by the increase in display ads, which have exceeded expectations. Analysts asked whether this was coming from ads on YouTube or DoubleClick networks -- two major acquisitions -- and the answer from Google executives was "both." The company does not break down the ad revenue from YouTube but the description on the conference call appears to be that YouTube and DoubleClick are both contributing to growth in Internet display advertising.

A question that's likely to dog Google in the future: the growth in expenses. There will be continue to be questions about profit margins. A lot of the growth in expenses can be attributed to employee growth. The company added 1,100 employees in the quarter, bringing its total headcount to 32,500 employees. It payed out $459 million in stock-based compensation in addition to having total non-GAAP operating expenses of $2.9 billion. That brought its non-GAAP operating margin to 38.2%, down from an operating margin of 40% in the same quarter of 2010.

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