Thursday, February 01, 2007

Color on quarter: Google (NASDAQ:GOOG)

Google's (NASDAQ:GOOG) 4th qtr report seems to be as uneventful as it can be for such an unpredictable monster.

- Bear Stearns believe that the main topic on investors' minds for Google's 4Q results, was how to gauge the organic growth rates and margins by excluding Checkout from the core results. They believe the true net revenue growth rate was not 19.6% but ~21% (when adjusting for the FX benefit and the negative impact from Checkout). EBITDA margins would increase from 62.1% reported to 63.6% PF (i.e. organic basis). Firm thinks this offsets some fears that Google's core margins are eroding significantly.

In addition to management's qualitative comments about the tremendous adoption of Google Checkout, firm's math indicates that Google processed ~$900M of transactions during the quarter. This would be a tremendous amount if correct in that it would represent about 12% of the domestic online non-credit card payment market.

- Citigroup notes that Google continues to execute very well, creating the opportunity for EBITDA margins to rise over time -- firm will continue to be contrarians on this point, although Q4 results don't provide any evidence. EBITDA margin was down 100 bps Y/Y to 62.1% and below firm's 63.3% estimate. The negative surprise was aggressive R&D spending and rising Other Cost of Revenue (data center/depreciation costs, credit card processing, payment processing, and content licensing costs). But firm continues to view R&D spending as a benign, somewhat discretionary source of margin pressure. And they view headcount ads as having flattened out at about 1,300 per quarter. And on a base of 11,000 employees that has to be less dilutive than on a base of 6,000 employees. So there should be leverage in this opex line at some point. The Other Cost of Revenue expense increase could, arguably, be more structural. Especially if content licensing costs are a major factor. But firm believes depreciation costs are more material here, creating the opportunity for long-term leverage from this line as well. In terms of the model, firm continues to forecast modest (40 bps) EBITDA margin expansion in 2007 and modest increases thereafter.

- JP Morgan notes that 4Q saw ~140 bps sequential erosion in Google's gross margins, to 86.7%. Firm believes the primary drivers for this erosion were: 1) rising TAC and 2) Checkout transaction processing fees

Traffic acquisition costs rose to 81.4% in 4Q'06, up 187 bps sequentially and 269 bps Y/Y. Firm believes the increase was due largely to the renegotiation of several big contracts - as well as new deals - with large partners, primarily AOL, MySpace and eBay. While firm thinks TAC rates are rising industry-wide, they believe Google's best-in-class monetization will allow it to remain profitable even in an environment where TAC rates are rising.

Google reported lower margins related partly due to credit card processing fees for Google Checkout. Google has been offering free processing to vendors who accept Checkout as a payment method. Although firm expects this promotion to continue to have a revenue impact in the short term, they believe the longer-term impact from high Checkout acceptance rates among online vendors could create significant revenue upside.

Notablecalls: While Google's growth is slowing (relatively talking of course, 70% y/y growth is nothing less than impressive), the main theme is costs assotiated with the future growth. I seems to me that costs are getting exponential compared to growth (data centers, hirings, TAC, content licencing etc), reducing the actual cash flow even when reported earnings still do not show it. As for the stock, don't really have a feeling except that I wouldn't buy the stock on this report.

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