Quick Thoughts: GOOG – Moonshots are Expensive


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–          GOOG missed 3Q14 EPS by 2.8%, failing to deliver an expected QoQ improvement in operating margins. Net sales were in line, with fractionally lower revenues offset by slightly better TAC.

–          Sales saw total paid clicks decelerate to 17% YoY growth, but cost per click was once again flat QoQ and down just 2% YoY, rebutting the popular bear narrative of chronic price deterioration.

–          Sites revenue grew 20% and “Other” revenue – including Play, devices, Docs and Compute Engine – grew 50%. Expenses were up nearly 30% YoY, driven by R&D and SG&A.

–          Modest CAPEX, up less than 6% YoY, may be a sign of future cost improvements, but like many other cloud-era leaders, GOOG is relatively unconcerned with delivering quarterly results.

Google missed its 3Q14 EPS bogie by $0.18, delivering $6.35, when the assembled sell side wanted $6.53. Predictably, in a tough tech tape, Google shares are trading down a bit over 2% after hours, drooping uncomfortably close to the 52 week low of $503. Still, despite the headline, 3Q14 was, more or less, a continuation of the trends set in the last couple of quarters.

Sales were, essentially, in line, up 20% YoY at $16.52B. While this was nominally $50M below the published revenue consensus, most investors care more about Google’s net sales after deducting traffic acquisition costs (TAC), and those were actually just a tick above expectations, since TAC was more than $50M lower than forecast. Inside the sales number, was more give and take. The total paid clicks were up just 17% YoY, decelerating from better than 25% click growth in each of the previous three quarters. Management drew a few questions about decelerating click growth on the conference call and asked investors not to panic, explaining that ad demand is pretty volatile quarter to quarter.

To the good side, the apparently all-important cost-per-click (CPC) metric, taken as a portent of certain doom when it showed accelerating declines during 2013 has been dead flat YTD in 2014, now off just 2% YoY all-in.  Importantly, advertising revenues from Google’s own sites grew 20%, in line with the business as a whole and a suggestion that the dominant on-line advertising platform continues to take market share as the ad biz picks up its digital spending.

It was nice to see “other” revenues rise 50% YoY and reach 11% of total sales. This category, which includes a hodgepodge of non-ad businesses like Google Play, Nexus and Chromecast devices, Google Compute Engine hosting, and Google Docs enterprise SaaS applications, is a welcome diversification from a reliance on advertising and a good example of the ways in which the company can leverage its core information processing assets.

The real reason for the EPS miss was expenses, which were up 30% YoY, squeezing operating margins by more than 200bp. The biggest culprit was R&D – on the call, CFO Pichette explained that 3Q just happened to be an extraordinary quarter for Google hiring, most of which happened to be engineers added to the R&D line. Apparently, this will NOT be the new normal, so analysts should go back to modeling declining R&D as a percent of sales from here. A nugget of good news for investors that didn’t hit the 3Q income statement – CAPEX spending was down QoQ and up less than 6% YoY. It’s still a big number at more than $2.4B, but it should allow the amortization expenses that flow through gross margins to taper off relative to sales.

So chalk 3Q14 as a miss. Undoubtedly, Google management doesn’t care about it much more than Jeff Bezos or Mark Zuckerberg care when their company’s disappoint investors for a quarter. For me, there was nothing here that requires a reassessment of my largely bullish take on Google’s future prospects. In a TMT world where cloud-based data processing will only get bigger and more important, Google is by far the best cloud-based data processing player in the world. I would be buying more shares tomorrow.

For our full research notes, please visit our published research site.

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