Google Inc.’s (GOOG) third quarter earnings blew past the Zacks Consensus, beating by 80 cents, or 13.5%.

Although the Zacks Consensus Estimate was closer to Google’s results when the company reported its second quarter results, estimates had dropped lower over the next 30 days, with analysts fearing a significant negative impact from Europe. However, the last 30 days saw estimates moving higher again, with 7 analysts raising and none moving in the opposite direction.

Google’s results clearly beat expectations, since shares showed limited movement during the day, but jumped 9.07% after hours.

Revenue

Gross revenue of $7.29 billion was up 6.8% sequentially and 22.6% year over year. Europe did not have too great an impact on results, although management stated that Southern European countries generally did better than some Northern European countries. A number of Asian countries also did well.

Revenues from both Google-owned and partner sites were up single-digits on a sequential basis and double-digits from the year-ago quarter. Google websites accounted for around 66% of quarterly revenue, while partner sites accounted for another 30%. Total advertising revenue was up 7.2% sequentially and 22.2% year over year.

Total traffic acquisition cost (the portion of revenue shared with Google’s partners) was up 4.1% sequentially and 14.2% from year-ago levels. However, traffic acquisition cost as a percentage of total advertising revenue was down 70 basis points (bps) sequentially and 142 bps from the year-ago quarter. Net advertising revenue, excluding traffic acquisition cost was down 2.6% sequentially.

Licensing and other fees brought in the remaining 4% of revenue in the last quarter.

By geography, the U.S. generated around 52% of revenue (up 6.8% sequentially), the U.K. generated 12% (up 9.1%), while other countries accounted for the balance (up 6.2%).

Margins

The gross margin of 65.0% was flat sequentially and up 115 bps sequentially and 242 bps from the year-ago quarter. The expansion in gross margin was the result of a 4% sequential and 16% year-over-year increase in the number of paid clicks, respectively, as well as a 2% sequential and 3% year-over-year increase in the cost per click, respectively.

Other costs, associated with data center operation, amortization of intangible assets, content acquisition and credit card processing increased from the year-ago quarter, partially offsetting the increases in paid clicks and the cost per click.

Operating expenses of $2.19 billion were higher than the previous quarter’s $1.99 billion. The operating margin was 35.0%, up 28 bps from the 34.7% recorded in the previous quarter. The increase was mainly on account of stronger gross margins, helped by slightly lower sales and marketing expenses. However, this was partially offset by higher R&D and G&A expenses, which were up 48 bps and 54 bps, respectively, as a percentage of sales.

The reason for the R&D increase is Google’s race to hire people it had severely cut down on in the 2007 timeframe. Moreover, the company completed a number of acquisitions in the last quarter, which also added to the workforce.
 
Google reported net income of $2.17 billion, or 29.7% of sales, compared to $1.84 billion, or 27.0% of sales in the June 2010 quarter and $1.64 billion, or 27.6% of sales in the year-ago quarter. GAAP earnings of $6.72 a share fell from $5.71 in the preceding quarter and $5.13 in the September quarter of 2009. There were no special items in the last quarter. Non-operating income jumped 142% sequentially and was a significant increase from a non-operating loss of $7.2 million in the year-ago quarter.

Balance Sheet

Google has a solid balance sheet, with cash and short-term investments of $24.49 billion, down $5.58 billion during the quarter. The company generated around $2.9 billion from operations in the last quarter and spent $757 million on capex, netting a free cash flow of $2.1 billion. Google has no debt.

In Conclusion

Google generates revenue primarily from the sale of advertising space on its online properties. The company is therefore, focused on user experience and convenience, which could bring back customers and generate new ones. It is already proved that the Google search engine generates more useful results than those from competitors, since it remains the most popular search engine in the world, despite growing competition from different sources. Google has also made acquisitions over time that have augmented its in-house capabilities.

However, search is not the only area of management focus. During the third quarter conference call, Google announced three other important growth engines—display, YouTube and mobile. We expect all three to increase in importance over the next few years.

For the first time, management provided some color on the revenue potential of each. Accordingly, it appears that display is already running at a $2.5 billion runrate and mobile at a $1 billion runrate. Additionally, YouTube is already monetizing over 2 billion views per week.

We have a Zacks #3 Rank and long term Neutral recommendation on Google shares, given the many moving parts in the business.
 
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