Quick Thoughts: Google and Amazon – Advertising? Good. Retail? Not So Much

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–          GOOG satisfied investors with a top-line beat, despite its MOT-driven EPS miss. AMZN tripped on both sales and earnings, evidence of a weak environment and delivery partner problems

–          GOOG ex MOT was strong – sales up 22% YoY, paid clicks up 13% QoQ, and cost per click down 2% vs. 3Q; The earnings miss was ALL on Motorola, which will be gone soon to Lenovo

–          AMZN’s revenue miss, on 20% sales growth, is evidence of a fairly soft Holiday retail market, while troubles with delivery partners may have hurt on both the top and bottom line

–          GOOG should ride a strong digital ad shift all year, unencumbered by MOT. AMZN’s soft 1Q guidance raises investor fears, but the long-term growth and profit opportunity is still intact

The two 1,000 pound gorillas of the Internet reported within minutes of each other Thursday night. Google hit the tape first with what, at first, seemed a mixed report that initially sent shares down in after hours, a trajectory that reversed itself once investors realized that the only bad news was in the Motorola Mobility business that had been sold to Lenovo for $2.9B this very morning. In contrast, Amazon disappointed all around – the stock started down and kept going, as squeamish holders sold out, wondering if Jeff Bezos deserved this much benefit of the doubt. Ultimately, I think the disparate results of the two can be tied to the relative fortunes of their core revenue drivers. The digital advertising market is on fire, while on-line shopping proved that it is not immune to the broader retail weakness.

First Google, which delivered top line growth of almost 22% ex-MOT. The company beat with $16.86B in revenue versus $16.76B expected by the street, and a slight EPS miss of $12.01 versus the $12.29 consensus. Google is staying the course riding the secular advertising shift to online, having grown paid clicks by 31% YoY. Its Traffic Acquisition Costs (TAC) hit a 3 year low as a percent of ad revenue to 23.5%. Google has a leg up over other online advertising platforms with its enhanced campaigns that are capable of showing advertisers critical metrics like ROI. It’s no surprise advertisers are embracing the product. But Motorola weighed heavily on the earnings miss as the unit has a per share operating loss of -$1.13 versus a -$0.45 loss during last year’s quarter, despite a string of product introductions over the past year that included the Moto X and Moto G handsets as well cost cutting initiatives within the unit. Wall Street breathed a sigh of relief yesterday when Larry Page confirmed GOOG would shed the deadweight division to Lenovo for $2.91B.Page incidentally is no longer joining the analyst call, which is now led by CFO Patrick Pichette and Chief Business Officer Nikesh Arora, and instead focusing energies on the business including playing a major role in recent M&A deals.

For Google, the foray into handset hardware threatened its ecosystem of Android partners, created confusion in the market place with its Nexus branded products, and failed to gain any share or increase profitability. While the deal will cull Motorola hardware, Google will still move ahead with its homegrown hardware, which includes Nexus smartphones/tablets, Chromebooks, and Chromecast. A slight increase in sales and marketing expenses as a percent of revenue during the quarter was attributable to marketing Chromebooks and the Chromecast. GOOG execs on the call didn’t specify how many of these devices were sold, but expressed satisfaction with momentum.

Particularly striking was the performance of its emerging businesses. Non-advertising revenue in the all encompassing “other” category, which includes the Google Play store, Chrome book hardware, the Nexus, as well as datacenter and enterprise revenue was up almost 99% YoY and non-ad revenue is now 10.5% of revenues versus 6.4% last year, sans Motorola of course. Management indicated Google Play apps and content were the biggest contributor to this growth, followed by the Nexus 5 and Chromecast.

Google also disclosed that it will move forward with its awaited complex stock split, which will create a new shareholder class with no voting power – so called “Class C” shares.  The shares will be distributed as a special dividend. One share of its Class C stock will be distributed to each share of voting class A stock owned as of March 27, the record date, and issued on April 2. The Class C shares will trade under the current “GOOG” ticker while the voting Class A shares will trade under “GOOGL.” The unusual split was favored by founders Sergey Brin and Larry Page so they may continue to control the company, while continuing to pay out shares to employees without diluting their stake. Brin and Page’s Class B shares give them 59% voting power and 15% ownership of Google. The split follows a shareholder lawsuit that was settled alleging the non-voting shares will trade at a discount. As part of the settlement, Google will pay Class C shareholders up to 5% of Class A share value should Class C share price fall at least 1% below parity in the next year. We anticipate that voting rights of Class A will hold a small premium over Class C shares but Google will not likely payout as it has the option of awarding more stock to settle. Aside from the EPS miss, there wasn’t much else to not like about Google’s quarter.

Next, Amazon delivered a slight disappointment missing both top and bottom lines and for the first time in recent memory and Wall Street failed to give Jeff Bezos a free pass. Revenue came in at $25.59B and lighter than the $26.06B expected. EPS also missed with $0.51 reported versus the $0.66 expected. Still, revenue was up a respectable 20% YoY for the quarter and up 22% for the FY. As usual, Amazon was cryptic with its earnings release giving little measureable insight for the shortfalls, blaming FX. The stock was down over 10% at one point after hours, but retreated somewhat after it revealed on the call that it is considering raising the price of its Prime subscription in the US by $20-40.

Amazon’s Prime service, which offers free unlimited 2-day shipping on eligible items as well as video streaming for an annual price of $79, has obviously helped Amazon grow its topline in the double digits since it was launched 9 years ago. Despite driving customer growth, the service has been a significant expense driving Amazon’s net shipping costs to 4.7% of revenue. For most high volume retailers 470 basis points is a lot of precious margin to be giving up as they generally have operating margins in the single digits. For Amazon, net shipping expenses are a necessary cost item to allow it a competitive advantage over its brick and mortar rivals. While Amazon hasn’t disclosed the precise number of Prime users, it mentioned in its release this time around that they are up to the tens of millions, which essentially means somewhere between 20M and 40M with the high end of the band determined by taking Amazon’s annual shipping revenue and dividing by $79. Naturally the higher end is lower given not all Amazon customers use Prime and we would be confident estimating sub numbers are somewhere in the 20s. It remains to be seen how a $20-40 annual increase in Prime fees would be accepted by the consumer, but we would bet that with all Amazon offers with the shipping and streaming price elasticity of demand is low in the sub $100 range. If anything, this is good news for investors.

Another bright spot in the quarter was growth in the “other” category, which is largely dominated by AWS revenues. It was up over 52% YoY and 21% sequentially. Amazon records AWS revenue in the North America “Other Segment” despite operating in over 190 countries. Cloud infrastructure is poised to become a big business, which we estimate will be worth $100B by 2020, and Amazon so far leads over rivals Google and Microsoft. With old paradigm names like IBM and HP behind having recently scrambled to break ground on data centers and weave together small scale data center acquisitions, Amazon is poised to have a large chunk of cloud infrastructure at the end of the decade.

A lot was expected this quarter of Amazon, especially with a weak brick and mortar retail environment and inclement weather and delivery issues with third parties like UPS failing to deliver gifts in time for the Christmas holiday. Further, guidance for Q1 2014 is weak with Amazon in typical form guiding to wide achievable bands. Despite the miss, Amazon still has strong positioning and signs of reigning in on Prime costs are an indication it’s taking profitability more seriously.

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