Google Misses Revs/EPS...and Pulls Out the "Display" Card

Google missed consensus revenue and EPS estimates. The stock was down 7% in the after-market.

The revenue shortfall came from Google Sites (vs. affiliates), due to a shortfall in paid-click growth, which saw a startling deceleration.  Adjusted operating income was slightly light and decelerated to a no-longer-extraordinary 41% from 47% in Q3. Free cash flow declined sequentially on the revenue miss and higher-than-expected capital expenditures.

Overall, net revenue decelerated sharply--from 62% growth in Q3 to 52% growth in Q4--after a series of quarters with only modest deceleration. This was the direct result of a drop in revenue unit (paid click) growth--to 30% in Q4 from 45% in Q3. Google did not have a good explanation for this drop, and, in fact, compounded the mystery by saying that click growth had exceeded its internal expectations.  In any event, the deceleration will almost certainly lead to multiple compression: Google's days of trading at 50X cash flow are likely behind it.

No impact from recession? Sergey says the company has not felt any impact from US economic woes. This would be one explanation for the slowdown in click growth. If Google hasn't felt impact yet, we imagine it soon will.

MySpace underperforming. One area of specific weakness: social networking. The company is having trouble monetizing "social networking" inventory (e.g., MySpace). Guaranteed payments to MySpace, et al, caused the "Traffic Acquisition Cost" rate to jump to almost 90% of network revenue from 84% last quarter. (The company said all social networking was weak, but as far as we know, it only has big guaranteed deals with MySpace.) This is not a big deal for Google, but unless Google can figure out a more effective monetization scheme, it's bad news for MySpace.

Display: Probably to address concerns about search product cycle slowdown, Eric did explicitly talk about entering the display ad business and about the large opportunities for YouTube. Flicking the display switch (adding, say, an ad to the front page) could result in billions of incremental revenue almost overnight. Google would presumably view this as a measure of last resort, but it's a testament to the company's awesome earnings power that it hasn't accepted a dime of display advertising yet. The YouTube ramp will take longer.

Release here. Model updated. 

KEY POINTS

• Net revenue miss: $3.39 billion vs. $3.45 billion estimate.
• EPS (Pro Forma) miss: $4.43-actual vs. $4.45 consensus (whisper was $4.49)
• Operating Income (pro forma) in-line to slight miss: $1.69 billion vs. $1.7 billion.
• Google Sites revenue slightly light: $3.12 vs. $3.2 consensus.  Google Network (less valuable) slightly ahead of consensus
• Paid click growth decelerates to 30% year over year from 45% in Q3. This is startling. Mystifyingly, the company says this exceeded its expectations, because Q3 was unusually strong (a clear hazard of not giving guidance).  This explanation does not jibe with quarterly trends, which showed a steady but modest deceleration through Q3, followed by a plunge in Q4.
  

SAI Spreadsheet: Google Financial Analysis

Q4 Key Metrics

• Gross Revenue: $4.83 billion, up 51%, in line (vs. 57% in Q3 and 58% in Q2)
• Net Revenue: $3.39 billion, up 52%, misses consensus of $3.45 billion (vs. 62% in Q3 and 63% in Q2)
• Operating Income (Adjusted): $1.69 billion vs consensus of about $1.7 billion, 49% of Net Revenue, down from 50% in Q3
• EPS: $4.43, misses consensus of $4.45 ($4.49 whisper)
• Google Sites Revenue: $3.12 billion, up 58%
  
• Google Network Revenue: $1.6 billion, up 37%, slightly exceeds consensus
• Free cash flow: Drops sequentially to $1.02 billion from $1.02 billion in Q3. Still extraordinary, obviously, but higher-than-expected CAPEX produces sequential decline.  
  

CONFERENCE CALL NOTES

Impact of quality improvement for AdSense for Content...fewer accidental clicks...may have reduced clicks.

Increase in TAC from guaranteed payments...social networking not monetizing as well as expected (i.e., MySpace)


Q&A
Meeker hits the critical issue: paid click growth decelerated to 30% y/y.  Company clearly regrets reporting this metric, but says click growth above their own internal expectations (which is very surprising).  Explanation--Q3 was unusually strong--doesn't jibe with quarterly trends. Also reveals a hazard of not giving guidance.

Amid battering from analysts on unit growth, CEO Schmidt jumps in to remind everyone about the display revenue and YouTube opportunities.  Out of character and probably a direct response to the quarter miss and resulting analyst pandemonium.

See Also: Why Wall Street Hates Google Now: That Wireless Thing