(01/23/12) What Google's Earnings Really Mean

First Apple surprised to the downside, and now it's Google's turn. Is this a portent of things to come in tech, or is this a point of inflection and a buying opportunity? So asks Jim Fink of Investing Daily.

The best time to invest in a stock is when expectations are low, not when they are sky high. Case in point: Google (GOOG).

Prior to the release of its fourth-quarter financial report, analysts were drooling over the prospect that Google’s earnings would top the $3 billion mark for the first time in the company’s 13-year history.

The optimism was based on comScore announcing two weeks ago that retail e-commerce spending for the entire November-December 2011 holiday season reached $37.2 billion, marking a 15% increase versus last year and an all-time record for the season.

Google makes most of its money from paid search, where retailers pay Google for prominent placement of advertisements in the search results of people’s Internet queries.

Since holiday shopping was so strong this year, the thinking was that retailers would be maxing out their advertising spending on Google Search like never before to ensure that they participated fully in the strong shopping season. As the recipient of these paid search advertising dollars, Google was expected to reap a financial windfall.

Oops.

Google reported only $2.71 billion in net income, which translated into a shockingly small year-over-year earnings growth rate of only 6%, far below the 36% and 26% year-over-year earnings growth achieved in the company’s previous two quarters. Even top-line net revenues of $8.13 billion fell short of analyst estimates of $8.4 billion, the first time in nine quarters that Google’s revenues had fallen short.

Some poor soul bought Google at $641 per share as the last trade prior to the market’s Thursday close. When the company released earnings after the bell and investors realized the miss, the stock fell more than 10% ($68) within six minutes, to a low of $573, before stabilizing after hours at $580.

Google CEO and co-founder Larry Page stated in the press release that “Google had a really strong quarter ending a great year,” but he apparently was the only one who thought so.

Google’s Cost-Per-Click is Declining
The cause of the earnings miss was two-fold. First, the average cost-per-click (CPC)—which measures the price advertisers pay Google each time a potential customer clicks on one of the advertisers’ links in the search results—fell 8% year-over-year, the first time CPCs had declined in more than two years (i.e., since 2009).

CEO Page said the decline was due to a weaker euro (translating into fewer US dollars), as well as a change in “mix,” where more clicks are occurring on mobile devices and on partner Web sites where CPC rates are traditionally lower.

Analysts aren't so sure, pointing to weakening demand in Europe (not just a currency effect) as a primary cause of the CPC decline. If true, than it proves that even high-growth Internet juggernauts like Google are not immune to the effects of an impending European recession.

There’s also the fear that something company-specific is wrong at Google. After all, other tech stocks like Intel (INTC), Microsoft (MSFT), and IBM (IBM) all posted stellar earnings and their stocks rose in response.

Google Spends Like a Drunken Sailor
Google differs from these other tech giants in its exorbitant rate of expense growth, which is the second cause of its earnings miss.

Google is hiring like crazy, with the number of employees up 4% in the last quarter, totaling 8,000 total new faces in 2011. Stock-based compensation skyrocketed 35% year-over-year, and the company spent $950 million on new infrastructure.

Many analysts are scratching their heads at Google’s $915 million foray into clean energy investments like solar energy company BrightSource, as well as its $12.5 billion acquisition of slow-growing cellphone manufacturer Motorola Mobility (MMI), which recently warned of worse-than-expected fourth-quarter earnings.

But Non-Search Initiatives Are Bearing Fruit
Google CEO Page—who replaced bean-counting Eric Schmidt last April—is famous for his disregard of Wall Street analysts and his willingness to forego short-term earnings gains in order to invest for future growth. Among the growth initiatives Page touted in the after-earnings conference call were:

Social networking site Google+ has more than doubled its global user base to 90 million in just the past three months, with more than 60% of users visiting the site daily
250 million Android devices in total, up by 50 million since November
More than 350 million active Gmail users
Google Chrome browser will overtake Firefox as second-most popular web browser by March

And despite the reduced CPC pricing, Google remains the king of search, with an increasing market share of 65.9% in December, far ahead of the 15% shares of search’s Tweedledum and Tweedledee—Microsoft’s Bing and Yahoo! Search.

Google Prognosis: Dead Money in the Short-Term
All in all, Google remains a great company of the future, but at its currently high valuation of 21.6 times earnings (above the expected five-year growth rate of only 18.6%) and 5.8 times sales (anything above 3.0 is really pricey), the stock may not recover quickly from today’s bloodbath until investors grow more comfortable with the global economic slowdown, Google’s spending, and the integration of Motorola Mobility.

Google doesn’t provide analysts with any forward-looking earnings guidance, so its caveat emptor for investors. I agree with the analysis of Colin Gillis of BGC Partners, who downgraded Google to “Hold” on the bad earnings release:

"We are downgrading as we see shares are range-bound until summer and Google’s stock may stall as the holiday season has passed, and the company struggles to integrate its low margin hardware acquisition [i.e., Motorola Mobility]...Looking into 2012, we see harder comparisons, the potential for a slowing macro economy, and significant margin impact from its pending hardware acquisition."

Longer-term than the next six months, Google stockholders should do just fine. Based on my chart-reading, the stock recently broke out on the upside from a two-year trading range between $450 and $640, hitting $670 earlier in January.

However, patience will be required, as a downward trip to the 200-day moving average of $563 seems likely.