Google’s Earnings Warn of Advertising Weakness

By Daniel James - October 23, 2012 | Tickers: AMZN, AAPL, GOOG | 0 Comments

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Introduction

Let me kick off this article by stating that Google (NASDAQ: GOOG) is one of my favorite companies. Not that this is particularly relevant for the analysis, but I wanted to have it said anyway. Despite the esteem I hold for this company and its products, Google’s most recent earnings report has me, and probably most investors, deeply worried about the current state of the tech sector. It is no surprise then that the Nasdaq was off about a percent that day, and a short-selling ban was enacted on Google during the trading session. In this article, I will investigate some of the warning signals this earnings report has set off.

Earnings Report

Due to a printer error, Google earnings were released more than 3 hours early last week, and they were pretty shocking to boot. Their earnings, usually so strong, missed by a whopping 15% with Q3 2012 EPS coming in at $9.03 versus a mean estimate of $10.65. Net revenue was 11.3 billion dollars, versus an estimate of 11.9 billion. The average cost per click, or CPC, an important measure of advertising income, was down 15% from last year. This is the 4^th consecutive quarter of CPC declines. Clearly, this was a terrible earnings report for the internet search titan. Consequently, shares took an 8% dive yesterday, shaving over $60 from the share price. Facebook, which has a similar income generation model, was down over 4%. Facebook has also been reporting disappointing advertising revenues, which is partly a result of their late adoption of new mobile technologies. Facebook still trades at over 100x earnings. 

Much of the weakness in this earnings report is attributed to poor performance in Google’s Motorola Mobility division, a company it acquired for $12.5 billion. In response to Google's report, BofA/Merril Lynch has already downgraded Google to neutral, and there may be more downgrades on the way. Motorola posted a 20% decline in net income. Clearly, Google is being outpaced by Apple in the mobile phone industry, if perhaps not in the mobile operating system division. While Google is struggling to turn around their new acquisition, it is the weakness in advertising revenue that has investors truly scared. Not only for Google’s revenue, but for all companies that rely on similar advertising models.

Site revenue was up only 15% YoY compared to 39% a year ago. Analysts worry these results indicate a secular change in the search engine industry, as consumers may be turning directly to sites such as Amazon (NASDAQ: AMZN) to find products. However, Amazon, despite being a great company with a huge market share, is a terribly overpriced stock trading at almost 300x earnings. Investors looking to get their feet wet in the tech sector would be better advised to consider other tech giants such as Google, despite this recent earnings miss. 

Valuation and Metrics

Of course, such a large drop in share prices impact the stock’s valuation, and it may be useful to reconsider some of these metrics. The P/E now stands at 22x earnings, compared to the 34.4x industry average, and the stock trades at 3.8 times book value. Apple (NASDAQ: AAPL), Google’s nemesis in the smartphone arena, has a considerably lower P/E of 14.8x, but trades at 5.45 price to book. Apple is perhaps the company that has been able to best capitalize on the smartphone revolution, and with a massive return on equity of 45.36, the stock has greatly rewarded investors. The stock is up over 60% in the last year, compared to Google's 15%. Still, all is not lost for Google. They still have an excellent operating margin of over 30%, and a return on equity of 18.57. Based on these valuations, those that maintain a bullish outlook on Google could consider getting in at this adjusted price.

Bottom Line

In conclusion, Google reported a bad earnings miss that set off alarm bells all over the industry. Declining advertising revenue, combined with weakness in the Motorola Mobility division, has investors and analysts deeply worried. Amid the gloom and doom earnings seasons, results like this do little to inspire confidence in the ailing tech sector, with one giant after another reporting disappointing revenues. It remains to be seen whether Google can revive its core advertising business, as well as its pricey acquisition of Motorola Mobility.

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