Google's Spendthrift Ways Spook Investors

Google (GOOG, $530.70, -47.81) announced its Q1 results last night. The company grew its top line by 27% year over year, topping expectations, but a 54% increase in spending and a clear signal from co-founder and new CEO Larry Page that the expenses would keep, sent investors running for the exits.

Page made a brief appearance on the earnings call last night, expressing optimism about the company's future and saying that management changes Google announced earlier in the year were "all working very well, exactly as planned." Page, who has a reputation for being media averse, exited and left CFO Patrick Pichette and other executives to answer analyst queries.

The costs increases stemmed from the company's announcement at the end of last year that it would increase salaries across the board by 10% and ramp up hiring. It added about 1,900 new employees during the quarter. Google's management argues that is battling other Silicon Valley tech firms for talent and the increased salary scales and aggressive hiring practices are necessary for it to remain a leader in the online industry. Google had over 26,000 employees at quarter end.

"Look, we’re nothing but very, very excited about our reporting 27% year-over-year revenue growth in Q1. This 27% proves really the logic behind our strategy, not only to invest heavily in our core search business and ads, but also in our new emerging businesses like display, like mobile, like enterprise," Pichette told analysts.

"From an investment perspective, our Q1 results don’t only show our continued commitment to invest in hiring, in marketing, and in the other areas; but they also, as you can see through our expenses, they reflect for the first time the full impact of the compensation changes we announced in Q4, the 10% salary increase," he added. "Google is clearly benefiting from and is also fueling the unrelenting pace of the digital economy that’s around us. And it’s growth we believe will benefit both Google, but in fact, the entire ecosystem for a long time to come."

The company reported an adjusted profit of $8.08 per share, which fell short of $8.10 that analysts were projecting as a result of margin pressure from its increased spending.

As reported according to GAAP, Google's profit was $2.3 billion, or $7.04 per share, compared with $1.96 billion, or $6.06 per share, in Q1 2010.

Google's gross revenue grew by 27% year over year to $8.58 billion; revenue excluding traffic acquisition costs (TAC) of $2.04 billion equaled $6.54 billion and easily topped the $6.31 billion Street estimate. Gross revenue grew by 2% from a strong Q4 2010; adjusted for FX and its hedging activities, it was up 1.2%.

The company's adjusted EBITDA equaled $3.63 billion, but the EBITDA margin was cut by -350 basis points sequentially to 55.5% from 59.0% in Q4.

Breaking down the results, revenue from Google's owned and operated (O&O) sites grew 33% year over to $5.88 billion, equal to 69% of total revenue and up 32% from a year ago.

Google’s partner sites generated $2.43 billion in revenues through its AdSense programs, which was 28% of total revenues. It represented a 19% increase year over year.

Other revenue was down -10% year over year to $269 million. Google booked revenue from its Nexus One mobile phone in the year-ago quarter but it has since been discontinued.

On a geographic basis, revenue from outside of the U.S. totaled $4.57 billion, or 53% of total revenues, up from 52% in Q4 and equal to the year-earlier percentage. On a currency neutral basis, the results would have been reduced by -$23 million, the company said. Revenues from the United Kingdom grew by 15% to $969 million, or 11% of the total, down from 13% of the total last year. The disaster in Japan "somewhat negatively" impacted the international results, Pichette said.

Global aggregate paid clicks grew by 18% year over year and 4% sequentially, which Pichette said reflected the accelerated shift of offline advertising to online. Aggregate cost per click (CPC) growth was up 8% year over year and down -1% sequentially. FX had little impact on CPC growth, Pichette added.

TAC expense was 25% of total advertising revenue; other cost of revenue equaled $897 million, including stock-based compensation of $49 million.

Operating expenses totaled $2.8 billion, including approximately $383 million in stock-based compensation. The increase year over year in OpEx was primarily due to payroll, increased advertising, and promotional spend, and some other professional services.

Operating cash flow equaled $3.2 billion. Google spent $890 million in CapEx in Q1. The majority of CapEx was related to facilities expenses and data center operations. Google bought two buildings in Q1, one in Dublin and one in Paris.

Analysts were mixed in their reaction to the company's results. Citigroup cut its rating on Google to a "hold" from a "buy," calling the stock a "show me story."

Colin Gillis of BGC Partners called the stock "dead money until summer," and criticized Page's brief remarks on the call.

"Our opinion was the 370-word introduction that was delivered by the CEO that did not include any comments on how he wanted to shape the company was lackluster," Gillis wrote. He also rates the stock a "hold."

Other more bullish analysts -- the overwhelming majority of the 41 analysts who follow the company rate the stock a "buy" or "strong buy" -- were more willing to wait and see, though several adjusted their targets and/or EPS estimates. The following comment from Benchmark Capital was typical of the bulls' camp:

"Google managed costs well through the recession but began to ramp expenses earlier than most. This proved successful as 2010 top-line growth accelerated to 26% from 10% in 2009. Based on this track record, we give Google the benefit of the doubt that investments will pay off and scale over time. Google’s primary areas of investment offer rewarding profit margins," the firm wrote.

BMR Take: Leaving aside the debate over whether Google is spending wisely or recklessly for one moment, its core business actually performed very well. The fact that revenue from its O&O sites is growing faster than network revenue is a good trend for Google as will drive down TAC expense as a percentage of revenue. The top-line growth was clearly excellent; Google shows no sign of losing appreciable search market share.

Google investors clearly aren't pleased with the company's increased spending, but the company's management is equally unapologetic about it. Several speakers talked about the array of new products Google has launched over the last 18 months, pointing to the success of Android in particular and noting that YouTube has become a solid platform for advertisers.

The fear is that Page will let spending get out of control; we agree that his first appearance as a CEO on a conference call was hardly inspiring. Many people are media shy, but hopefully he'll get some coaching because a CEO that can't articulate a clear strategy is not going to inspire investor confidence even if he is a tech genius and a co-founder of the company.

Trading at about 11x the slightly revised 2012 EPS consensus of $39.66, minus its approximately $97 per share in net cash and investments, we think the stock looks undervalued, but agree that the shares are likely to be range bound until investors get a better handle on its long-term expenses and margins. We would put a target of around $735 on the stock, which is a 16x multiple of 2012 EPS excluding its net cash. We note as well that Google's stock has tended to trade lower in the summer when traffic declines and then picks up steam in the second half of the year. As such we think interested investors will be able to ease into the name over the next couple of months.