XNAS:GOOG Google Inc Class C Quarterly Report 10-Q Filing - 6/30/2012

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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 000-50726

 

 

Google Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   77-0493581

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

1600 Amphitheatre Parkway

Mountain View, CA 94043

(Address of principal executive offices, including zip code)

(650) 253-0000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

   Large accelerated filer  x    Accelerated filer  ¨   
Non-accelerated filer (Do not check if a smaller reporting company)  ¨             Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At July 19, 2012, there were 261,972,044 shares of Google’s Class A common stock outstanding and 65,061,280 shares of Google’s Class B common stock outstanding.

 

 

 


Table of Contents

Google Inc.

Form 10-Q

For the Quarterly Period Ended June 30, 2012

TABLE OF CONTENTS

 

          Page No.  
Note About Forward-Looking Statements      1   
PART I. FINANCIAL INFORMATION   

Item 1

   Financial Statements      3   
   Consolidated Balance Sheets—December 31, 2011 and June 30, 2012 (unaudited)      3   
   Consolidated Statements of Income—Three and Six Months Ended June 30, 2011 and 2012 (unaudited)      4   
   Consolidated Statements of Comprehensive Income—Three and Six Months Ended June 30, 2011 and 2012 (unaudited)      5   
   Consolidated Statements of Cash Flows—Six Months Ended June 30, 2011 and 2012 (unaudited)      6  
   Notes to Consolidated Financial Statements (unaudited)      7   

Item 2

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      29   

Item 3

   Quantitative and Qualitative Disclosures About Market Risk      46   

Item 4

   Controls and Procedures      47   
PART II. OTHER INFORMATION   

Item 1

   Legal Proceedings      48   

Item 1A

   Risk Factors      48   

Item 2

   Unregistered Sales of Equity Securities and Use of Proceeds      62   

Item 5

   Other Information      62   

Item 6

   Exhibits      62   
   Signature      63   
   Exhibit Index      64   

 

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NOTE ABOUT FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding:

 

   

the growth of our business and revenues and our expectations about the factors that influence our success;

 

   

seasonal fluctuations in internet usage and traditional retail seasonality, which are likely to cause fluctuations in our quarterly results;

 

   

our plans to continue to invest in systems, facilities, and infrastructure, increase our hiring, provide competitive compensation programs, and continue our current pace of acquisitions;

 

   

the potential for declines in our revenue growth rate;

 

   

our expectation that growth in advertising revenues from our websites will continue to exceed that from our Google Network Members’ websites, which will have a positive impact on our operating margins;

 

   

our expectation that we will continue to pay most of the fees we receive from advertisers to our Google Network Members;

 

   

our expectations about the impact of our acquisition of Motorola Mobility Holdings, Inc. (Motorola) on our results and business and our ability to realize the expected benefits from the acquisition and successfully implement our plans and expectations for Motorola’s business;

 

   

our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks;

 

   

fluctuations in aggregate paid clicks and average cost-per-click;

 

   

our belief that our foreign exchange risk management program will not fully offset the exposure to fluctuations in foreign currency exchange rates;

 

   

the increase of costs related to hedging activities under our foreign exchange risk management program;

 

   

our expectation that our cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues;

 

   

our potential exposure in connection with pending investigations and proceedings;

 

   

our expectations about our board of directors’ intention to declare a dividend of shares of the new Class C capital stock, as well as the timing of that dividend, if declared and paid;

 

   

our expectation that our traffic acquisition costs will fluctuate in the future;

 

   

continued investments in international markets;

 

   

our future compensation expenses;

 

   

fluctuations in our effective tax rate;

 

   

the sufficiency of our sources of funding;

 

   

our payment terms to certain advertisers, which may increase our working capital requirements; and

 

   

fluctuations in our capital expenditures;

as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 1A, “Risk Factors.” Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (SEC). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

As used herein, “Google,” “we,” “our,” and similar terms include Google Inc. and its subsidiaries, unless the context indicates otherwise.

 

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“Google” and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.

 

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PART I—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

Google Inc.

CONSOLIDATED BALANCE SHEETS

(In millions, except share and par value amounts which are reflected in thousands,

and par value per share amounts)

 

     As of
December 31,
2011
     As of
June 30,
2012
 
            (unaudited)  

Assets

     

Current assets:

     

Cash and cash equivalents

   $ 9,983       $ 15,437   

Marketable securities

     34,643         27,685   
  

 

 

    

 

 

 

Total cash, cash equivalents, and marketable securities (including securities loaned of $2,778 and $2,789)

     44,626         43,122   

Accounts receivable, net of allowance of $133 and $187

     5,427         6,866   

Inventories

     35         634   

Receivable under reverse repurchase agreements

     745         475   

Deferred income taxes, net

     215         146   

Prepaid revenue share, expenses and other assets

     1,710         2,614   
  

 

 

    

 

 

 

Total current assets

     52,758         53,857   

Prepaid revenue share, expenses and other assets, non-current

     499         2,263   

Non-marketable equity securities

     790         1,040   

Property and equipment, net

     9,603         10,909   

Intangible assets, net

     1,578         7,862   

Goodwill

     7,346         10,120   
  

 

 

    

 

 

 

Total assets

   $ 72,574       $ 86,051   
  

 

 

    

 

 

 

Liabilities and Stockholders’ Equity

     

Current liabilities:

     

Accounts payable

   $ 588       $ 2,419   

Short-term debt

     1,218         3,218   

Accrued compensation and benefits

     1,818         1,626   

Accrued expenses and other current liabilities

     1,370         2,750   

Accrued revenue share

     1,168         1,175   

Securities lending payable

     2,007         1,916   

Deferred revenue

     547         767   

Income taxes payable, net

     197         157   
  

 

 

    

 

 

 

Total current liabilities

     8,913         14,028   

Long-term debt

     2,986         2,987   

Deferred revenue, non-current

     44         97   

Income taxes payable, non-current

     1,693         1,898   

Deferred income taxes, net, non-current

     287         1,509   

Other long-term liabilities

     506         811   

Stockholders’ equity:

     

Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding

             0   

Class A and Class B common stock and additional paid-in capital, $0.001 par value per share: 9,000,000 shares authorized (Class A 6,000,000, Class B 3,000,000) and 12,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000); 324,895 (Class A 257,553, Class B 67,342) and par value of $325 (Class A $258, Class B $67) and 326,944 (Class A 261,584, Class B 65,360) and par value of $327 (Class A $262, Class B $65) shares issued and outstanding

     20,264         21,357   

Class C capital stock, $0.001 par value per share: 3,000,000 shares authorized; no shares issued and outstanding

     0         0   

Accumulated other comprehensive income

     276         84   

Retained earnings

     37,605         43,280   
  

 

 

    

 

 

 

Total stockholders’ equity

     58,145         64,721   
  

 

 

    

 

 

 

Total liabilities and stockholders’ equity

   $ 72,574       $ 86,051   
  

 

 

    

 

 

 

See accompanying notes.

 

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Google Inc.

CONSOLIDATED STATEMENTS OF INCOME

(In millions, except per share amounts)

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2012      2011      2012  
     (unaudited)  

Revenues:

           

Google (advertising and other)

   $ 9,026       $ 10,964       $ 17,602       $ 21,609   

Motorola (hardware and other)

     0         1,250         0         1,250   

Costs and expenses:

           

Cost of revenues – Google (advertising and other) (1)

     3,172         3,984         6,107         7,773   

Cost of revenues – Motorola (hardware and other) (1)

     0         1,029         0         1,029   

Research and development (1)

     1,234         1,585         2,456         3,026   

Sales and marketing (1)

     1,091         1,433         2,117         2,702   

General and administrative(1)

     648         980         1,244         1,737   

Charge related to the resolution of Department of Justice investigation

     0         0         500         0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total costs and expenses

     6,145         9,011         12,424         16,267   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income from operations

     2,881         3,203         5,178         6,592   

Interest and other income, net

     204         254         300         410   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     3,085         3,457         5,478         7,002   

Provision for income taxes

     580         672         1,174         1,327   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 2,505       $ 2,785       $ 4,304       $ 5,675   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income per share of Class A and Class B common stock:

           

Basic

   $ 7.77       $ 8.54       $ 13.37       $ 17.42   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted

   $ 7.68       $ 8.42       $ 13.19       $ 17.17   
  

 

 

    

 

 

    

 

 

    

 

 

 

(1)         Includes stock-based compensation expense as follows:

           

Cost of revenues – Google (advertising and other)

   $ 51       $ 82       $ 100       $ 156   

Cost of revenues – Motorola (hardware and other)

     0         5         0         5   

Research and development

     247         291         484         590   

Sales and marketing

     74         120         152         217   

General and administrative

     63         160         130         246   

See accompanying notes.

 

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Google Inc.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In millions)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Net income

   $ 2,505      $ 2,785      $ 4,304      $ 5,675   

Other comprehensive income (loss):

        

Change in foreign currency translation adjustment

     119        (433     457        (318

Available-for-sale investments:

        

Change in net unrealized gains

     169        14        165        210   

Less: reclassification adjustment for net gains included in net income

     (61     (41     (79     (148
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change (net of tax effect of $19, $28, $2, and $10)

     108        (27     86        62   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cash flow hedges:

        

Change in unrealized gains

     (3     174        (66     139   

Less: reclassification adjustment for gains included in net income

     (3     (52     (12     (75
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change (net of tax effect of $4, $72, $55, and $38)

     (6     122        (78     64   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

     221        (338     465        (192
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 2,726      $ 2,447      $ 4,769      $ 5,483   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes.

 

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Google Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

 

     Six Months Ended
June 30,
 
     2011     2012  
     (unaudited)  

Operating activities

  

Net income

   $ 4,304      $ 5,675   

Adjustments:

    

Depreciation and amortization of property and equipment

     648        851   

Amortization of intangible and other assets

     208        330   

Stock-based compensation expense

     866        1,214   

Excess tax benefits from stock-based award activities

     (33     (55

Deferred income taxes

     464        191   

Gain on sale of marketable equity securities

     0        (44

Gain on divestiture of business

     0        (188

Other

     55        (12

Changes in assets and liabilities, net of effects of acquisitions and divestiture:

    

Accounts receivable

     (24     79   

Income taxes, net

     (98     1,169   

Inventories

     (1     170   

Prepaid revenue share, expenses and other assets

     (147     (1,188

Accounts payable

     77        (80

Accrued expenses and other liabilities

     297        (243

Accrued revenue share

     6        23   

Deferred revenue

     69        54   
  

 

 

   

 

 

 

Net cash provided by operating activities

     6,691        7,946   
  

 

 

   

 

 

 

Investing activities

    

Purchases of property and equipment

     (1,807     (1,381

Purchases of marketable securities

     (20,955     (15,542

Maturities and sales of marketable securities

     13,627        22,657   

Investments in non-marketable equity securities

     (343     (202

Cash collateral related to securities lending

     (424     (91

Investments in reverse repurchase agreements

     (270     270   

Acquisitions, net of cash acquired and proceeds received from divestiture, and purchases of intangible and other assets

     (863     (9,946
  

 

 

   

 

 

 

Net cash used in investing activities

     (11,035     (4,235
  

 

 

   

 

 

 

Financing activities

    

Net proceeds (payments) from stock-based award activities

     88        (184

Excess tax benefits from stock-based award activities

     33        55   

Proceeds from issuance of debt, net of costs

     8,030        7,751   

Repayment of debt

     (7,304     (5,753
  

 

 

   

 

 

 

Net cash provided by financing activities

     847        1,869   
  

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     187        (126
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (3,310     5,454   

Cash and cash equivalents at beginning of year

     13,630        9,983   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 10,320      $ 15,437   
  

 

 

   

 

 

 

Supplemental disclosures of cash flow information

    

Cash paid for taxes

   $ 864      $ 1,003   

Cash paid for interest

   $ 0      $ 37   

Non-cash financing activity:

    

Fair value of stock-based awards assumed in connection with acquisition of Motorola

   $ 0      $ 41   

See accompanying notes.

 

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Google Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Google Inc. and Summary of Significant Accounting Policies

Nature of Operations

We were incorporated in California in September 1998. We were re-incorporated in the State of Delaware in August 2003. We generate revenues primarily by delivering relevant, cost-effective online advertising in our Google segment. In addition, as a result of our acquisition of Motorola Mobility Holdings, Inc. (Motorola) on May 22, 2012, we generate revenues from sales of mobile devices in our Motorola Mobile (Mobile) segment and digital set-top boxes in our Motorola Home (Home) segment. See Notes 8 and 14 for further discussion of the acquisition and our segment information.

Basis of Consolidation

The consolidated financial statements include the accounts of Google Inc. and our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated.

Unaudited Interim Financial Information

The accompanying Consolidated Balance Sheet as of June 30, 2012, the Consolidated Statements of Income for the three and six months ended June 30, 2011 and 2012, the Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2011 and 2012, and the Consolidated Statements of Cash Flows for the six months ended June 30, 2011 and 2012 are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). In our opinion, the unaudited interim consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of our financial position as of June 30, 2012, our results of operations for the three and six months ended June 30, 2011 and 2012, and our cash flows for the six months ended June 30, 2011 and 2012. The results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012.

These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed with the SEC on January 26, 2012.

Prior period balance related to inventories has been reclassified to conform to the current year presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, inventory valuation, intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of stock-based awards, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

 

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Revenue Recognition

The following table presents our revenues by revenue source (in millions, unaudited):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2012      2011      2012  

Google:

           

Advertising revenues:

           

Google websites

   $ 6,232       $ 7,542       $ 12,111       $ 14,854   

Google Network Members’ websites

     2,484         2,983         4,911         5,896   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total advertising revenues

     8,716         10,525         17,022         20,750   

Other revenues

     310         439         580         859   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Google revenues (advertising and other)

     9,026         10,964         17,602         21,609   

Motorola:

           

Total Motorola revenues (hardware and other)

     0         1,250         0         1,250   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

   $ 9,026       $ 12,214       $ 17,602       $ 22,859   
  

 

 

    

 

 

    

 

 

    

 

 

 

We recognize revenues when the services or goods have been provided or delivered, the fees we charge are fixed or determinable, we and our advertisers or other customers understand the specific nature and terms of the agreed upon transactions, and collectability is reasonably assured.

Google

Google AdWords is our auction-based advertising program that enables advertisers to place text-based and display ads on our websites and our Google Network Members’ websites. Display advertising comprises the videos, text, images, and other interactive ads that run across the web on computers and mobile devices, including smart phones and handheld computers such as netbooks and tablets. Most of our AdWords customers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user clicks on one of its ads. We also offer AdWords on a cost-per-impression basis that enables advertisers to pay us based on the number of times their ads appear on our websites and our Google Network Members’ websites as specified by the advertisers.

Google AdSense refers to the online programs through which we distribute our advertisers’ AdWords ads for display on our Google Network Members’ websites, as well as programs to deliver ads on television broadcasts.

We recognize as revenues the fees charged to advertisers each time a user clicks on one of the ads that appears next to the search results or content on our websites or our Google Network Members’ websites. For those advertisers using our AdWords cost-per-impression pricing, we recognize as revenues the fees charged to advertisers each time their ads are displayed on our websites or our Google Network Members’ websites. We report our Google AdSense revenues on a gross basis principally because we are the primary obligor to our advertisers.

We record deferred revenue upon invoicing or when cash payments are received in advance of our performance in the underlying agreement in the accompanying Consolidated Balance Sheets.

 

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Motorola

Our Motorola business is comprised of two operating segments. The Mobile segment is focused on mobile wireless devices and related products and services. The Home segment is focused on technologies and devices that provide video entertainment services to consumers by enabling subscribers to access a variety of interactive digital television services.

For hardware product sales, revenue recognition generally occurs when products have been shipped, risk of loss has transferred to the customer, objective evidence exists that customer acceptance provisions have been met, no significant obligations remain and allowances for discounts, price protection, returns and customer incentives can be reasonably and reliably estimated. Recorded revenues are reduced by these allowances. Where these allowances cannot be reasonably and reliably estimated, we recognize revenue at the time the product sells through the distribution channel to the end customer.

For arrangements that include multiple deliverables, primarily for products that contain software essential to the hardware products’ functionality and services, we allocate revenue to each unit of accounting based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling prices to be used for allocating revenue: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE generally exists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis.

Inventories

Inventories are stated at the lower of cost or market, computed using the first-in, first-out method.

 

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Note 2. Net Income Per Share of Class A and Class B Common Stock

The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock (in millions, except share amounts which are reflected in thousands and per share amounts):

 

    Three Months Ended
June 30,
    Six Months Ended
June 30,
 
    2011     2012     2011     2012  
    (unaudited)  
    Class A     Class B     Class A     Class B     Class A     Class B     Class A     Class B  

Basic net income per share:

               

Numerator

               

Allocation of undistributed earnings

  $ 1,967      $ 538      $ 2,223      $ 562      $ 3,372      $ 932      $ 4,519      $ 1,156   

Denominator

               

Weighted-average common shares outstanding

    253,080        69,148        260,390        65,882        252,150        69,728        259,417        66,369   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Number of shares used in per share computation

    253,080        69,148        260,390        65,882        252,150        69,728        259,417        66,369   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Basic net income per share

  $ 7.77      $ 7.77      $ 8.54      $ 8.54      $ 13.37      $ 13.37      $ 17.42      $ 17.42   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted net income per share:

               

Numerator

               

Allocation of undistributed earnings for basic computation

  $ 1,967      $ 538      $ 2,223      $ 562      $ 3,372      $ 932      $ 4,519      $ 1,156   

Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares

    538        0        562        0        932        0        1,156        0   

Reallocation of undistributed earnings to Class B shares

    0        (6     0        (7     0        (11     0        (16
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allocation of undistributed earnings

  $ 2,505      $ 532      $ 2,785      $ 555      $ 4,304      $ 921      $ 5,675      $ 1,140   

Denominator

               

Number of shares used in basic computation

    253,080        69,148        260,390        65,882        252,150        69,728        259,417        66,369   

Weighted-average effect of dilutive securities

               

Add:

               

Conversion of Class B to Class A common shares outstanding

    69,148        0        65,882        0        69,728        0        66,369        0   

Employee stock options, including warrants issued under Transferable Stock Option program

    2,653        43        2,857        38        2,990        49        2,907        40   

Restricted stock units

    1,155        0        1,664        0        1,341        0        1,771        0   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Number of shares used in per share computation

    326,036        69,191        330,793        65,920        326,209        69,777        330,464        66,409   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted net income per share

  $ 7.68      $ 7.68      $ 8.42      $ 8.42      $ 13.19      $ 13.19      $ 17.17      $ 17.17   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

The net income per share amounts are the same for Class A and Class B common stock because the holders of each class are legally entitled to equal per share distributions whether through dividends or in liquidation.

 

11


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Note 3. Cash and Investments

Cash, cash equivalents, and marketable securities consisted of the following (in millions):

 

     As of
December 31,
2011
     As of
June 30,
2012
 
            (unaudited)  

Cash and cash equivalents:

     

Cash

   $ 4,712       $ 7,463   

Cash equivalents:

     

Time deposits

     534         436   

Money market and other funds (1)

     4,462         7,538   

U.S. government agencies

     275         0   
  

 

 

    

 

 

 

Total cash and cash equivalents

     9,983         15,437   
  

 

 

    

 

 

 

Marketable securities:

     

Time deposits

     495         404   

U.S. government agencies

     6,226         2,184   

U.S. government notes

     11,579         8,933   

Foreign government bonds

     1,629         1,606   

Municipal securities

     1,794         1,382   

Corporate debt securities

     6,112         6,118   

Agency residential mortgage-backed securities

     6,501         6,942   

Marketable equity securities

     307         116   
  

 

 

    

 

 

 

Total marketable securities

     34,643         27,685   
  

 

 

    

 

 

 

Total cash, cash equivalents, and marketable securities

   $ 44,626       $ 43,122   
  

 

 

    

 

 

 

 

(1)

The balances at December 31, 2011 and June 30, 2012 included $1.3 billion and $1.4 billion of cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months. See below for further discussion on this program.

The following tables summarize unrealized gains and losses related to our investments in marketable securities designated as available-for-sale (in millions):

 

     As of December 31, 2011  
     Adjusted
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 

Time deposits

   $ 495       $ 0       $ 0      $ 495   

U.S. government agencies

     6,211         15         0        6,226   

U.S. government notes

     11,475         104         0        11,579   

Foreign government bonds

     1,608         32         (11     1,629   

Municipal securities

     1,775         19         0        1,794   

Corporate debt securities

     6,023         187         (98     6,112   

Agency residential mortgage-backed securities

     6,359         147         (5     6,501   

Marketable equity securities

     228         79         0        307   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 34,174       $ 583       $ (114   $ 34,643   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

12


Table of Contents
     As of June 30, 2012  
     Adjusted
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (unaudited)  

Time deposits

   $ 404       $ 0       $ 0      $ 404   

U.S. government agencies

     2,166         18         0        2,184   

U.S. government notes

     8,852         81         0        8,933   

Foreign government bonds

     1,562         50         (6     1,606   

Municipal securities

     1,364         18         0        1,382   

Corporate debt securities

     5,877         273         (32     6,118   

Agency residential mortgage-backed securities

     6,796         149         (3     6,942   

Marketable equity securities

     127         6         (17     116   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 27,148       $ 595       $ (58   $ 27,685   
  

 

 

    

 

 

    

 

 

   

 

 

 

Gross unrealized gains and losses on cash equivalents were not material at December 31, 2011 and June 30, 2012.

We recognized gross realized gains of $94 million and $135 million for the three and six months ended June 30, 2011 and $76 million and $209 million for the three and six months ended June 30, 2012. We recognized gross realized losses of $19 million and $33 million for the three and six months ended June 30, 2011 and $21 million and $34 million for the three and six months ended June 30, 2012. We determine realized gains and losses on the sale of marketable securities on a specific identification method, and we reflect such gains and losses as a component of interest and other income, net, in the accompanying Consolidated Statements of Income.

The following table summarizes the estimated fair value of our investments in marketable securities, excluding marketable equity securities, designated as available-for-sale and classified by the contractual maturity date of the securities (in millions):

 

     As of
June 30,
2012
 
     (unaudited)  

Due in 1 year

   $ 5,753   

Due in 1 year through 5 years

     8,300   

Due in 5 years through 10 years

     5,301   

Due after 10 years

     8,215   
  

 

 

 

Total

   $ 27,569   
  

 

 

 

The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2011 and June 30, 2012, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions):

 

     As of December 31, 2011  
     Less than 12 Months     12 Months or Greater     Total  
     Fair Value      Unrealized
Loss
    Fair Value      Unrealized
Loss
    Fair Value      Unrealized
Loss
 

Foreign government bonds

   $ 302       $ (11   $ 6       $ 0      $ 308       $ (11

Corporate debt securities

     2,160         (97     17         (1     2,177         (98

Agency residential mortgage-backed securities

     716         (3     19         (2     735         (5
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 3,178       $ (111   $ 42       $ (3   $ 3,220       $ (114
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

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Table of Contents
     As of June 30, 2012  
     Less than 12 Months     12 Months or Greater     Total  
     Fair Value      Unrealized
Loss
    Fair Value      Unrealized
Loss
    Fair Value      Unrealized
Loss
 
     (unaudited)  

Foreign government bonds

   $ 397       $ (4   $ 9       $ (2   $ 406       $ (6

Corporate debt securities

     827         (24     157         (8     984         (32

Agency residential mortgage-backed securities

     704         (3     0         0        704         (3

Marketable equity securities

     93         (17     0         0        93         (17
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,021       $ (48   $ 166       $ (10   $ 2,187       $ (58
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Securities Lending Program

From time to time, we enter into securities lending agreements with financial institutions to enhance investment income. We loan selected securities which are secured by collateral in the form of cash or securities. Cash collateral is invested in reverse repurchase agreements. We classify loaned securities as cash equivalents or marketable securities in the accompanying Consolidated Balance Sheets. We record the cash collateral as an asset with a corresponding liability. We classify reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements in the accompanying Consolidated Balance Sheets. For lending agreements collateralized by securities, we do not record an asset or liability as we are not permitted to sell or repledge the associated collateral.

Note 4. Debt and Credit Facility

Short-Term Debt

We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. At December 31, 2011 and June 30, 2012, we had $750 million and $2.8 billion of outstanding commercial paper recorded as short-term debt with weighted-average interest rate of 0.1%.

We have a secured promissory note in the amount of $468 million with an interest rate of 1.0% maturing in December 2012. Proceeds were used for the acquisition of an office building in New York City. As of December 31, 2011 and June 30, 2012, the outstanding balance was $468 million.

The estimated fair value of the short-term debt approximated its carrying value at December 31, 2011 and June 30, 2012.

Long-Term Debt

In May 2011, we issued $3.0 billion of unsecured senior notes in three tranches as described in the table below (collectively, the Notes) (in millions):

 

     Outstanding
Balance
as of
June 30,
2012
 
     (unaudited)  

1.25% Notes due on May 19, 2014

   $ 1,000   

2.125% Notes due on May 19, 2016

     1,000   

3.625% Notes due on May 19, 2021

     1,000   

Unamortized discount for the Notes above

     (13
  

 

 

 

Total

   $ 2,987   
  

 

 

 

 

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Table of Contents

The effective interest yields of the 2014, 2016, and 2021 Notes were 1.258%, 2.241%, and 3.734%. Interest on the Notes is payable semi-annually in arrears on May 19 and November 19 of each year. We may redeem the Notes at any time in whole or from time to time in part at specified redemption prices. We are not subject to any financial covenants under the Notes. We used the net proceeds from the issuance of the Notes to repay a portion of our outstanding commercial paper and for general corporate purposes. The total estimated fair value of the Notes was approximately $3.2 billion, which is based on quoted prices for our publicly-traded debt as of June 30, 2012.

Credit Facility

In conjunction with the commercial paper program, we have a $3.0 billion revolving credit facility expiring in July 2016. The interest rate for the credit facility is determined based on a formula using certain market rates. At December 31, 2011 and June 30, 2012, we were in compliance with the financial covenant in the credit facility and no amounts were outstanding.

Note 5. Derivative Financial Instruments

We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We use certain interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and our anticipated debt issuance. Our program is not designated for trading or speculative purposes.

We recognize derivative instruments as either assets or liabilities in the accompanying Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the accompanying Consolidated Statements of Income as interest and other income, net, as part of revenues, or to accumulated other comprehensive income (AOCI) in the accompanying Consolidated Balance Sheets.

Cash Flow Hedges

We use foreign currency options designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. The notional principal of foreign exchange contracts to purchase U.S. dollars with Euros was 2.8 billion (or approximately $3.8 billion) and 3.8 billion (or approximately $4.9 billion) at December 31, 2011 and June 30, 2012; the notional principal of foreign exchange contracts to purchase U.S. dollars with British pounds was £1.4 billion (or approximately $2.2 billion) and £1.7 billion (or approximately $2.6 billion) at December 31, 2011 and June 30, 2012; and the notional principal of foreign exchange contracts to purchase U.S. dollars with Canadian dollars was C$504 million (or approximately $490 million) and C$615 million (or approximately $591 million) at December 31, 2011 and June 30, 2012. These foreign exchange contracts have maturities of 36 months or less.

During the second quarter of 2012, we began to hedge the variability of forecasted interest payments using forward-starting interest swaps. The total notional amount of these forward-starting interest swaps was $1.0 billion as of June 30, 2012 with terms calling for us to receive interest at a variable rate and to pay interest at a fixed rate. These forward-starting interest swaps effectively fix the benchmark interest rate on an anticipated debt issuance of $1.0 billion in 2014, and they will be terminated upon issuance of the debt.

We initially report any gain or loss on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify to revenues or interest expense when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI would be reclassified to interest and other income, net. Further, we exclude the change in the time value of the options from our assessment of hedge effectiveness. We record the premium paid or time value of an option on the date of purchase as an asset. Thereafter, we recognize any change to this time value in interest and other income, net.

At June 30, 2012, the effective portion of our cash flow hedges before tax effect was $255 million, of which $201 million is expected to be reclassified from AOCI to revenues within the next 12 months.

Fair Value Hedges

We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. Gains and losses on these contracts are recognized in interest and other income, net, along with the offsetting losses and gains of the related hedged items. We exclude changes in the time value for forward contracts from the assessment of hedge effectiveness and recognize them in interest and other income, net. The notional principal of foreign exchange contracts to purchase U.S. dollars with foreign currencies was $1.0 billion and $1.0 billion at December 31, 2011 and June 30, 2012.

 

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Table of Contents

Other Derivatives

Other derivatives not designated as hedging instruments consist of forward and option contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts as well as the related costs in interest and other income, net, along with the losses and gains of the related hedged items. The notional principal of foreign exchange contracts to purchase U.S. dollars with foreign currencies was $2.3 billion and $3.1 billion at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to sell U.S. dollars for foreign currencies was $472 million and $453 million at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to purchase Euros with other foreign currencies was 711 million (or approximately $929 million) and 786 million (or approximately $979 million) at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to sell Euros for other foreign currencies was 10 million (or approximately $12 million) at June 30, 2012 and no such contracts were outstanding at December 31, 2011.

We also use exchange-traded interest rate futures contracts and “To Be Announced” (TBA) forward purchase commitments of mortgage-backed assets to hedge interest rate risks on certain fixed income securities. The TBA contracts meet the definition of derivative instruments in cases where physical delivery of the assets is not taken at the earliest available delivery date. Our interest rate futures and TBA contracts (together interest rate contracts) are not designated as hedging instruments. We recognize gains and losses on these contracts as well as the related costs in interest and other income, net. The gains and losses are generally economically offset by unrealized gains and losses in the underlying available-for-sale securities, which are recorded as a component of AOCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from AOCI into interest and other income, net. The total notional amounts of interest rate contracts outstanding were $100 million at December 31, 2011 and no such contracts were outstanding at June 30, 2012.

The fair values of our outstanding derivative instruments were as follows (in millions):

 

    

Balance Sheet Location

   Fair Value of Derivative Instruments  
        As of
December 31,
2011
     As of
June 30,
2012
 
                 (unaudited)  

Derivative Assets

        

Derivatives designated as hedging instruments:

        

Foreign exchange contracts

   Prepaid revenue share, expenses and other assets, current and non-current    $ 333       $ 395   

Derivatives not designated as hedging instruments:

        

Foreign exchange contracts

   Prepaid revenue share, expenses and other assets, current      4         14   
     

 

 

    

 

 

 

Total

      $ 337       $ 409   
     

 

 

    

 

 

 

Derivative Liabilities

        

Derivatives designated as hedging instruments:

        

Foreign exchange contracts

   Accrued expenses and other current liabilities    $ 5       $ 2   

Derivatives not designated as hedging instruments:

        

Foreign exchange contracts

   Accrued expenses and other current liabilities      1         0   
     

 

 

    

 

 

 

Total

      $ 6       $ 2   
     

 

 

    

 

 

 

 

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Table of Contents

The effect of derivative instruments in cash flow hedging relationships on income and AOCI is summarized below (in millions):

 

Derivatives in Cash Flow Hedging Relationship

   Increase (Decrease) in Gains Recognized in AOCI
on Derivatives Before Tax Effect (Effective Portion)
 
     Three Months Ended June 30,      Six Months Ended June 30,  
     2011     2012      2011     2012  
     (unaudited)  

Foreign exchange contracts

   $ (6   $ 275       $ (115   $ 220   

 

Derivatives in Cash Flow Hedging Relationship

   Gains Reclassified from AOCI into Income (Effective Portion)  
            Three Months Ended June 30,      Six Months Ended June 30,  
     Location      2011      2012      2011      2012  
            (unaudited)  

Foreign exchange contracts

     Revenues       $ 4       $ 81       $ 18       $ 119   

 

Derivatives in Cash Flow Hedging Relationship

   Gains (Losses) Recognized in Income on Derivatives (Amount
Excluded from Effectiveness Testing and Ineffective Portion)(1)
 
          Three Months Ended June 30,     Six Months Ended June 30,  
     Location    2011     2012     2011     2012  
          (unaudited)  

Foreign exchange contracts

   Interest and
other income, net
   $ (58   $ (120   $ (171   $ (246

 

(1) 

Gains (losses) related to the ineffective portion of the hedges were not material in all periods presented.

The effect of derivative instruments in fair value hedging relationship on income is summarized below (in millions):

 

Derivatives in Fair Value Hedging Relationship

   Gains (Losses) Recognized in Income on Derivatives(2)  
          Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     Location    2011     2012     2011     2012  
          (unaudited)  

Foreign exchange contracts

   Interest and other
income, net
   $ (21   $ 36      $ (59   $ 16   

Hedged item

   Interest and other
income, net
     18        (38     53        (21
     

 

 

   

 

 

   

 

 

   

 

 

 
      $ (3   $ (2   $ (6   $ (5
     

 

 

   

 

 

   

 

 

   

 

 

 

 

(2) 

Losses related to the amount excluded from effectiveness testing of the hedges were $3 million and $6 million for the three and six months ended June 30, 2011, and $2 million and $5 million for the three and six months ended June 30, 2012.

The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions):

 

Derivatives not Designated as Hedging Instruments

   Gains (Losses) Recognized in Income on Derivatives  
          Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     Location    2011     2012     2011     2012  
          (unaudited)  

Foreign exchange contracts

   Interest and other
income, net
   $ (7   $ 0      $ 0      $ (25

Interest rate contracts

   Interest and other
income, net
     (9     (7     (9     (5
     

 

 

   

 

 

   

 

 

   

 

 

 
      $ (16   $ (7   $ (9   $ (30
     

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

Note 6. Fair Value Measurements

We measure our cash equivalents, marketable securities, auction rate securities (ARS), and foreign currency and interest rate derivative contracts at fair value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A three-tier fair value hierarchy is established as a basis for considering such assumptions and for inputs used in the valuation methodologies in measuring fair value:

Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 - Include other inputs that are directly or indirectly observable in the marketplace.

Level 3 - Unobservable inputs that are supported by little or no market activities.

The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

We classify our cash equivalents and marketable securities within Level 1 or Level 2. This is because we value our cash equivalents and marketable securities using quoted market prices or alternative pricing sources and models utilizing market observable inputs. We classify our investments in ARS within Level 3 because they are valued using valuation models with significant unobservable marketable inputs. We classify our foreign currency and interest rate derivative contracts primarily within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments.

Assets and liabilities measured at fair value on a recurring basis are summarized below (in millions):

 

Description

          Fair Value Measurement at Reporting Date Using  
   As of
December 31,
2011
     Quoted Prices
in Active Markets
for Identical Assets
(Level 1)
     Significant Other
Observable
Inputs
(Level 2)
    Significant
Unobservable
Inputs
(Level 3)
 

Assets

          

Cash equivalents:

          

Time deposits

   $ 534       $ 0       $ 534      $ 0   

Money market and other funds

     4,462         3,202         1,260 (1)      0   

U.S. government agencies

     275         0         275        0   

Marketable securities:

          

Time deposits

     495         0         495        0   

U.S. government agencies

     6,226         0         6,226        0   

U.S. government notes

     11,579         11,579         0        0   

Foreign government bonds

     1,629         0         1,629        0   

Municipal securities

     1,794         0         1,794        0   

Corporate debt securities

     6,112         0         6,112        0   

Agency residential mortgage-backed securities

     6,501         0         6,501        0   

Marketable equity securities

     307         307         0        0   

Derivative contracts

     337         0         337        0   

Auction rate securities

     118         0         0        118   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 40,369       $ 15,088       $ 25,163      $ 118   
  

 

 

    

 

 

    

 

 

   

 

 

 

Liabilities

          

Derivative contracts

   $ 6       $ 0       $ 6      $ 0   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 6       $ 0       $ 6      $ 0   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) 

This balance represents cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months.

 

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Description

          Fair Value Measurement at Reporting Date Using  
   As of
June 30,
2012
     Quoted Prices
in Active Markets
for Identical Assets
(Level 1)
     Significant Other
Observable
Inputs
(Level 2)
    Significant
Unobservable
Inputs
(Level 3)
 
     (unaudited)  

Assets

  

Cash equivalents:

          

Time deposits

   $ 436       $ 0       $ 436      $ 0   

Money market and other funds

     7,840         6,407         1,433 (1)      0   

Marketable securities:

          

Time deposits

     404         0         404        0   

U.S. government agencies

     2,184         0         2,184        0   

U.S. government notes

     8,933         8,933         0        0   

Foreign government bonds

     1,606         0         1,606        0   

Municipal securities

     1,382         0         1,382        0   

Corporate debt securities

     6,118         0         6,118        0   

Agency residential mortgage-backed securities

     6,942         0         6,942        0   

Marketable equity securities

     116         116         0        0   

Derivative contracts

     409         0         409        0   

Auction rate securities

     86         0         0        86   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 36,456       $ 15,456       $ 20,914      $ 86   
  

 

 

    

 

 

    

 

 

   

 

 

 

Liabilities

          

Derivative contracts

   $ 2       $ 0       $ 2      $ 0   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 2       $ 0       $ 2      $ 0   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) 

This balance represents cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months.

Note 7. Balance Sheet Components

Inventories

Inventories consisted of the following (in millions):

 

     As of
December 31,
2011
     As of
June 30,
2012
 
            (unaudited)  

Raw materials and work in process

   $ 0       $ 159   

Finished goods

     35         475   
  

 

 

    

 

 

 

Inventories

   $ 35       $ 634   
  

 

 

    

 

 

 

Property and Equipment

Property and equipment consisted of the following (in millions):

 

     As of
December 31,
2011
     As of
June 30,
2012
 
            (unaudited)  

Information technology assets

   $ 6,060       $ 6,869   

Land and buildings

     5,228         5,829   

Construction in progress

     2,128         2,232   

Leasehold improvements

     919         1,139   

Furniture and fixtures

     65         68   
  

 

 

    

 

 

 

Total

     14,400         16,137   

Less: accumulated depreciation and amortization

     4,797         5,228   
  

 

 

    

 

 

 

Property and equipment, net

   $ 9,603       $ 10,909   
  

 

 

    

 

 

 

 

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Accumulated Other Comprehensive Income

The components of accumulated other comprehensive income were as follows (in millions):

 

     As of
December 31,
2011
    As of
June 30,
2012
 
           (unaudited)  

Foreign currency translation adjustment

   $ (148   $ (466

Net unrealized gains on available-for-sale investments, net of taxes

     327        389   

Unrealized gains on cash flow hedges, net of taxes

     97        161   
  

 

 

   

 

 

 

Accumulated other comprehensive income

   $ 276      $ 84   
  

 

 

   

 

 

 

Note 8. Acquisitions

On May 22, 2012, we completed our acquisition of Motorola, a provider of innovative technologies, products and services that enable a range of mobile and wireline digital communication, information and entertainment experiences. The acquisition is expected to protect and advance our Android ecosystem and enhance competition in mobile computing. Under the transaction, we acquired all outstanding common shares of Motorola for $40 per share and all vested Motorola stock options and restricted stock units, for a total purchase price of approximately $12.4 billion in cash. In addition, we assumed $401 million of unvested Motorola stock options and restricted stock units, which will be recorded as stock-based compensation expense over the weighted-average remaining service periods of approximately 2.9 years. Transaction costs were approximately $50 million, which were recorded as general and administrative expense as incurred.

The fair value of assets acquired and liabilities assumed was based upon a preliminary valuation and our estimates and assumptions are subject to change within the measurement period. The primary areas of the purchase price that are not yet finalized are related to certain legal matters, income taxes, and residual goodwill. Of the $12.4 billion total purchase price, $2.9 billion was cash acquired, $5.5 billion was attributed to patents and developed technology, $2.6 billion to goodwill, $730 million to customer relationships, and $670 million to other net assets acquired.

The goodwill of $2.6 billion is primarily attributed to the synergies expected to arise after the acquisition. The amount of goodwill expected to be deductible for tax purposes is zero.

Supplemental information on an unaudited pro forma basis, as if the Motorola acquisition had been consummated on January 1, 2011, is presented as follows (in millions, except per share amounts):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2012      2011      2012  
     (unaudited)  

Revenues

   $ 12,310       $ 13,929       $ 23,822          $ 26,379   

Net income

   $ 2,284       $ 2,802       $ 3,679          $ 5,490   

Net income per share of Class A and Class B common stock – diluted

   $ 7.00       $ 8.46       $ 11.26          $ 16.59   

These pro forma results are based on estimates and assumptions, which we believe are reasonable. They are not necessarily indicative of our consolidated results of operations in future periods or the results that actually would have

 

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been realized had we been a combined company during the periods presented. The pro forma results include adjustments primarily related to amortization of acquired intangible assets, severance and benefit arrangements in connection with the acquisition, and stock-based compensation expenses for assumed unvested stock options and restricted stock units.

During the six months ended June 30, 2012, we completed 24 other acquisitions and purchases of intangible assets for a total cash consideration of approximately $458 million, of which $245 million was attributed to goodwill, $230 million to acquired intangible assets, and $17 million to net liabilities assumed. These acquisitions generally enhance the breadth and depth of our expertise in engineering and other functional areas, our technologies, and our product offerings. The amount of goodwill expected to be deductible for tax purposes is zero.

Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate.

For all acquisitions completed during the six months ended June 30, 2012, patents and developed technology have a weighted-average useful life of 9.0 years, customer relationships have a weighted-average useful life of 7.5 years and trade names and other have a weighted-average useful life of 9.3 years.

Note 9. Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill for the six months ended June 30, 2012 were as follows (in millions, unaudited):

 

Balance as of December 31, 2011

   $ 7,346   

Goodwill acquired

     2,831   

Goodwill adjustment

     (57
  

 

 

 

Balance as of June 30, 2012

   $ 10,120   
  

 

 

 

As a result of the acquisition of Motorola, we have three operating segments: Google, Mobile, and Home. Amounts of goodwill allocated to the Mobile and Home segments were not material. See Note 14 for further discussion of segment information.

Information regarding our acquisition-related intangible assets is as follows (in millions):

 

     As of December 31, 2011  
     Gross
Carrying
Amount
     Accumulated
Amortization
     Net
Carrying
Value
 

Patents and developed technology

   $ 1,451       $ 698       $ 753   

Customer relationships

     1,288         573         715   

Trade names and other

     359         249         110   
  

 

 

    

 

 

    

 

 

 

Total

   $ 3,098       $ 1,520       $ 1,578   
  

 

 

    

 

 

    

 

 

 
     As of June 30, 2012  
     Gross
Carrying
Amount
     Accumulated
Amortization
     Net
Carrying
Value
 
     (unaudited)  

Patents and developed technology

   $ 7,127       $ 875       $ 6,252   

Customer relationships

     2,048         688         1,360   

Trade names and other

     519         269         250   
  

 

 

    

 

 

    

 

 

 

Total

   $ 9,694       $ 1,832       $ 7,862   
  

 

 

    

 

 

    

 

 

 

 

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Amortization expense of acquisition-related intangible assets was $106 million and $201 million for the three and six months ended June 30, 2011 and $193 million and $317 million for the three and six months ended June 30, 2012. As of June 30, 2012, expected amortization expense for acquisition-related intangible assets for each of the next five years and thereafter was as follows (in millions, unaudited):

 

Remainder of 2012

   $ 622   

2013

     1,108   

2014

     1,036   

2015

     883   

2016

     824   

2017

     780   

Thereafter

     2,609   
  

 

 

 
   $ 7,862   
  

 

 

 

Note 10. Interest and Other Income, Net

The components of interest and other income, net, were as follows (in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Interest income

   $ 212      $ 180      $ 402      $ 362   

Interest expense

     (13     (22     (17     (42

Realized gains on available-for-sale investments, net

     75        55        102        175   

Foreign currency exchange losses, net

     (72     (149     (200     (292

Gain on divestiture of business

     0        188        0        188   

Other

     2        2        13        19   
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest and other income, net

   $ 204      $ 254      $ 300      $ 410   
  

 

 

   

 

 

   

 

 

   

 

 

 

Note 11. Contingencies

Legal Matters

Antitrust Investigations

On June 23, 2011, we received a Civil Investigative Demand (CID) from the U.S. Federal Trade Commission’s (FTC) Bureau of Competition and a subpoena from FTC’s Bureau of Consumer Protection relating to a review by the FTC of our business practices, including search and advertising. State attorneys general from the states of Texas, Ohio, and Mississippi have issued similar CIDs. We are cooperating with the FTC and the state attorneys general and are responding to their information requests.

The European Commission’s (EC) Directorate General for Competition has also opened an investigation into various antitrust-related complaints against us. On February 10, 2010, we received notification from the EC about three antitrust complaints filed by Ciao, Ejustice, and Foundem, respectively. On November 30, 2010, the EC formally opened proceedings against us. Since November 2010, 1plusV, parent company of Ejustice, and VfT, an association of business listings providers in Germany, have filed similar complaints against us. On March 31, 2011, Microsoft Corporation submitted a similar complaint to the EC against us. On the same day, the EC notified us of additional complaints filed by Elfvoetbal, Hotmaps, Interactive Lab, and nnpt.it, and on August 30, 2011 of a complaint by dealdujour.pro. In addition, in December 2011, the Spanish Association of Daily Newspaper Publishers also submitted a complaint to the EC against us. In January 2012, Twenga brought a complaint against us and, in February 2012, the German newspaper associations, Bundesverband Deutscher Zeitungsverleger (BDZV) and Verband Deutscher Zeitschriftenverleger (VDZ), also brought a complaint against us with the EC. In March and April of 2012, the EC asked us to comment on Expedia’s, Tripadvisor’s, Odigeo’s and Streetmap’s complaints against us. We believe we have adequately responded to all of the allegations made against us. We are cooperating with the EC and responding to its information requests.

 

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Argentina’s Comision Nacional de Defensa de la Competencia, the Competition Commission of India, and the Korea Fair Trade Commission in South Korea have also opened an investigation into certain business practices.

EPA Investigation

In February 2009, we learned of a U.S. Environmental Protection Agency (EPA) investigation into an alleged release of refrigerant at one of our smaller data center facilities, which we acquired from DoubleClick, and the accuracy of related statements and records. We are cooperating with the EPA and have provided documents and other materials.

Patent and Intellectual Property Claims

We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies, including Android, Google Search, Google AdWords, Google AdSense, Google Books, Google News, Google Image Search, Google Chrome, Google Talk, Google Voice, Motorola devices and YouTube, infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the ITC (U.S. International Trade Commission) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss for a company or its suppliers in an ITC action could result in a prohibition on importing infringing products into the U.S. Since the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products.

Furthermore, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business.

Other

We are also regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust (such as the pending investigations by the FTC and the EC described above), intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury and other matters. Such claims, suits, government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences.

Certain of our outstanding legal matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred, and the amount can be reasonably estimated. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters.

With respect to our outstanding legal matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in the aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such legal matters is inherently unpredictable and subject to significant uncertainties.

We expense legal fees in the period in which they are incurred.

 

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Income Taxes

We are under audit by the Internal Revenue Service (IRS) and various other tax authorities. We have reserved for potential adjustments to our provision for income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities, and we believe that the final outcome of these examinations or agreements will not have a material effect on our results of operations. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in the recognition of tax benefits in the period we determine the liabilities are no longer necessary. If our estimates of the federal, state, and foreign income tax liabilities are less than the ultimate assessment, a further charge to expense would result.

Note 12. Stockholders’ Equity

The following table presents the weighted-average assumptions used to estimate the fair values of the stock options granted in the period presented:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Risk-free interest rate

     2.5     1.0     2.4     1.0

Expected volatility

     33     29     33     29

Expected life (in years)

     6.2        5.3        5.8        5.3   

Dividend yield

     0        0        0        0   

Weighted-average estimated fair value of options granted during the period

   $ 209.97      $ 193.80      $ 210.28      $ 193.80   

There were no stock options granted during the three months ended March 31, 2012.

 

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Table of Contents

The following table summarizes the activities for our stock options for the six months ended June 30, 2012:

 

     Options Outstanding  
     Number of
Shares
    Weighted-
Average
Exercise Price
     Weighted-
Average
Remaining
Contractual
Term
(in years)
     Aggregate
Intrinsic
Value
(in millions) (1)
 
     (unaudited)  

Balance at December 31, 2011

     9,807,252      $ 357.92         

Granted (2)

     1,374,577      $ 578.12         

Exercised

     (734,011   $ 297.48         

Forfeited/canceled

     (98,652   $ 429.36         
  

 

 

         

Balance at June 30, 2012

     10,349,166      $ 390.77         5.7       $ 2,016   
  

 

 

         

Vested and exercisable as of June 30, 2012

     6,798,207      $ 333.88         4.4       $ 1,677   

Vested and exercisable as of June 30, 2012 and expected to vest thereafter (3)

     9,881,860      $ 385.63         5.7       $ 1,971   

 

(1) 

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the closing stock price of $580.07 of our Class A common stock on June 29, 2012.

(2)

Includes options granted in connection with the acquisition of Motorola.

(3)

Options expected to vest reflect an estimated forfeiture rate.

 

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Table of Contents

The following table summarizes additional information regarding outstanding, exercisable, and vested and exercisable stock options at June 30, 2012:

 

Options Outstanding

     Options Exercisable      Options Vested and
Exercisable
 

Range of Exercise

Prices

   Number of
Shares
     Weighted-
Average
Remaining
Life
(in years)
     Weighted-
Average
Exercise
Price
     Number of
Shares
     Weighted-
Average
Exercise
Price
     Number of
Shares
     Weighted-
Average
Exercise
Price
 
                   (unaudited)                       

$0.30–$94.80

     251,940         2.0       $ 27.39         251,940       $ 27.39         243,207       $ 25.28   

$117.84–$198.41

     348,960         2.3       $ 179.09         348,960       $ 179.09         348,960       $ 179.09   

$205.96–$298.86

     461,483         2.7       $ 277.11         459,762       $ 277.07         459,762       $ 277.07   

$300.97–$399.00

     4,937,566         4.4       $ 309.67         4,102,720       $ 309.64         4,102,720       $ 309.64   

$401.78–$499.07

     1,284,132         6.6       $ 443.89         841,902       $ 442.43         841,902       $ 442.43   

$501.27–$595.35

     1,932,984         7.8       $ 535.85         708,037       $ 527.57         708,037       $ 527.57   

$601.17–$699.35

     1,132,021         9.5       $ 628.94         93,539       $ 612.46         93,539       $ 612.46   

$710.84

     80         5.5       $ 710.84         80       $ 710.84         80       $ 710.84   
  

 

 

          

 

 

       

 

 

    

$0.30–$710.84

     10,349,166         5.7       $ 390.77         6,806,940       $ 333.56         6,798,207       $ 333.88   
  

 

 

          

 

 

       

 

 

    

The above tables include approximately 1.4 million warrants held by selected financial institutions that were stock options purchased from employees under our Transferable Stock Option (TSO) program, with a weighted-average exercise price of $347.61 and a weighted-average remaining life of 1.1 years.

During the six months ended June 30, 2012, the number of shares underlying TSOs sold to selected financial institutions under the TSO program was 493,534 at a total value of $132 million, or an average price of $267.73 per share, including an average premium of $11.08 per share. The premium is calculated as the difference between (a) the sale price of the TSO and (b) the intrinsic value of the TSO, which we define as the excess, if any, of the price of our Class A common stock at the time of the sale over the exercise price of the TSO.

The total grant date fair value of stock options vested during the three and six months ended June 30, 2011 was $123 million and $250 million. The total grant date fair value of stock options vested during the three and six months ended June 30, 2012 was $162 million and $288 million. The aggregate intrinsic value of all stock options and warrants exercised during the three and six months ended June 30, 2011 was $68 million and $313 million. The aggregate intrinsic value of all stock options and warrants exercised during the three and six months ended June 30, 2012 was $68 million and $232 million. These amounts do not include the aggregate sales price of stock options sold under our TSO program.

As of June 30, 2012, there was $567 million of unrecognized compensation cost related to outstanding stock options. This amount is expected to be recognized over a weighted-average period of 2.4 years. To the extent the forfeiture rate is different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations.

The following table summarizes the activities for our unvested restricted stock units (RSUs) for the six months ended June 30, 2012:

 

     Unvested Restricted Stock Units  
     Number of
Shares
    Weighted-
Average
Grant-Date
Fair Value
 
     (unaudited)  

Unvested at December 31, 2011

     8,822,648      $ 520.27   

Granted(1)

     5,594,051      $ 516.45   

Vested

     (1,740,221   $ 491.76   

Forfeited/canceled

     (307,095   $ 519.09   
  

 

 

   

Unvested at June 30, 2012

     12,369,383      $ 522.56   
  

 

 

   

Expected to vest after June 30, 2012 (2 )

     10,741,572      $ 522.56   

 

(1) 

Includes RSUs granted in connection with the acquisition of Motorola.

(2) 

RSUs expected to vest reflect an estimated forfeiture rate.

 

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As of June 30, 2012, there was $5.5 billion of unrecognized compensation cost related to unvested RSUs. This amount is expected to be recognized over a weighted-average period of 3.0 years. To the extent the actual forfeiture rate is different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations.

Stock Dividend

In April 2012, our board of directors approved amendments to our certificate of incorporation that would, among other things, create a new class of non-voting capital stock (Class C capital stock). The amendments authorize 3 billion shares of Class C capital stock and also increase the authorized shares of Class A common stock from 6 billion to 9 billion. The amendments are reflected in our Fourth Amended and Restated Certificate of Incorporation (New Charter), the adoption of which was approved by stockholders at our 2012 Annual Meeting of Stockholders held on June 21, 2012. We have announced the intention of our board of directors to consider a distribution of shares of the Class C capital stock as a dividend to our holders of Class A and Class B common stock (Dividend). The Class C capital stock will have no voting rights, except as required by applicable law. Except as expressly provided in the New Charter, shares of Class C capital stock will have the same rights and privileges and rank equally, share ratably and be identical in all other respects to the shares of Class A common stock and Class B common stock as to all matters.

The par value per share of our shares of Class A common stock and Class B common stock will remain unchanged at $0.001 per share after the Dividend. On the effective date of the Dividend, there will be a transfer between retained earnings and common stock and the amount transferred will be equal to the $0.001 par value of the Class C capital stock that is issued. We will give retroactive effect to prior period share and per share amounts in our consolidated financial statements for the effect of the Dividend, such that prior periods are comparable to current period presentation.

Note 13. Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Our total unrecognized tax benefits were $1,564 million and $1,755 million as of December 31, 2011 and June 30, 2012. Our total unrecognized tax benefits that, if recognized, would affect our effective tax rate were $1,350 million and $1,528 million as of December 31, 2011 and June 30, 2012. Our existing tax positions will continue to generate an increase in liabilities for unrecognized tax benefits.

Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Note 14. Information about Segments and Geographic Areas

Prior to the second quarter of 2012, our chief operating decision makers (i.e., chief executive officer and his direct reports) reviewed financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of allocating resources and evaluating financial performance. As a result of our Motorola acquisition in the second quarter of 2012, our chief operating decision makers review financial information for the following three operating segments:

 

   

Google – includes our advertising and other non-advertising businesses

 

   

Mobile – includes our mobile device business acquired from Motorola

 

   

Home – includes our digital set-top box business acquired from Motorola

Our chief operating decision makers do not evaluate operating segments using asset information.

 

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The following table sets forth revenues and operating income (loss) by operating segment (in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011      2012     2011      2012  
     (unaudited)  

Google:

          

Revenues

   $ 9,026       $ 10,964      $ 17,602       $ 21,609   

Operating income

     3,316         3,988        6,544         7,933   

Mobile:

          

Revenues

     0         843        0         843   

Operating loss

     0         (41     0         (41

Home:

          

Revenues

     0         407        0         407   

Operating income

     0         3        0         3   

A reconciliation of the total segment operating income to the consolidated operating income is as follows (in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Total segment operating income

   $ 3,316      $ 3,950      $ 6,544      $ 7,895   

Unallocated items

     (435     (747     (1,366     (1,303
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated operating income

   $ 2,881      $ 3,203      $ 5,178      $ 6,592   
  

 

 

   

 

 

   

 

 

   

 

 

 

Unallocated items including stock-based compensation expense, a charge related to severance and benefit arrangements in connection with the Motorola acquisition, and a charge related to resolution of Department of Justice investigation, are not allocated to each segment because we do not include this information in our measurement of the performance of our operating segments.

Revenues by geography are based on the billing addresses of our customers for the Google segment, and the ship-to addresses of our customers for the Mobile and the Home segments. The following tables set forth revenues and long-lived assets by geographic area (in millions):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2012      2011      2012  
     (unaudited)  

Revenues:

           

United States

   $ 4,155       $ 5,696       $ 8,160       $ 10,570   

United Kingdom

     976         1,186         1,946         2,336   

Rest of the world

     3,895         5,332         7,496         9,953   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

   $ 9,026       $ 12,214       $ 17,602       $ 22,859   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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     As of
December 31,
2011
     As of
June 30,
2012
 
            (unaudited)  

Long-lived assets:

     

United States

   $ 15,963       $ 19,265   

International

     3,853         12,929   
  

 

 

    

 

 

 

Total long-lived assets

   $ 19,816       $ 32,194   
  

 

 

    

 

 

 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Overview

Google is a global technology leader focused on improving the ways people connect with information. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world. Our mission is to organize the world’s information and make it universally accessible and useful. We serve three primary constituencies:

 

   

Users. We provide users with products and services that enable people to more quickly and easily find, create, and organize information that is useful to them.

 

   

Advertisers. We provide advertisers with cost-effective ways to deliver online and offline ads to customers across Google-owned websites and through the Google Network, which is the network of third parties that use our advertising programs to deliver relevant ads with their search results and content.

 

   

Google Network Members and Other Content Providers. We provide members of our Google Network with our Google AdSense programs. These include programs through which we distribute our advertisers’ AdWords ads for display on the websites of our Google Network Members. We share most of the fees these ads generate with our Google Network Members, thereby creating an important revenue stream for them. In addition, we have entered into arrangements with other content providers under which we distribute or license their video and other content, and we may display ads next to or as part of this content on the pages of our websites. We share most of the fees these ads generate with these content providers, thereby creating an important revenue stream for these partners.

 

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As a result of our acquisition of Motorola, we also provide innovative technologies, products and services that enable a range of mobile and wireline digital communication, information and entertainment experiences. Motorola’s integrated products and platforms deliver rich multimedia content, such as voice, video, messaging and Internet-based applications and services to multiple screens, such as mobile devices, including smartphones and media tablets, televisions and personal computers.

Our Motorola business is comprised of two segments. The Mobile segment is focused on mobile wireless devices and related products and services. The Home segment is focused on technologies and devices that provide video entertainment services to consumers by enabling subscribers to access a variety of interactive digital television services.

Recent Development

In April 2012, our board of directors approved amendments to our certificate of incorporation that would, among other things, create Class C capital stock. The amendments authorize 3 billion shares of Class C capital stock and also increase the authorized shares of Class A common stock from 6 billion to 9 billion. The amendments are reflected in our New Charter, the adoption of which was approved by stockholders at our 2012 Annual Meeting of Stockholders held on June 21, 2012. We have announced the intention of our board of directors to consider a distribution of shares of the Class C capital stock as a dividend to our holders of Class A and Class B common stock. The Class C capital stock will have no voting rights, except as required by applicable law. Except as expressly provided in the New Charter, shares of Class C capital stock will have the same rights and privileges and rank equally, share ratably and be identical in all other respects to the shares of Class A common stock and Class B common stock as to all matters.

How We Generate Revenue

We generate revenues from our Google business primarily by delivering online advertising, and from our Motorola business primarily by selling hardware products.

Google (Advertising and Other)

Advertising revenues made up 97% of our Google revenues for the three and six months ended June 30, 2011 and 96% of our Google revenues for the three and six months ended June 30, 2012. We derive most of our other revenues from our enterprise products, as well as our display advertising management services to advertisers, ad agencies, and publishers.

Google AdWords is our auction-based advertising program that enables advertisers to place text-based and display ads on our websites and our Google Network Members’ websites. Display advertising comprises the videos, text, images, and other interactive ads that run across the web on computers and mobile devices, including smart phones and handheld computers such as netbooks and tablets. Most of our AdWords advertisers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user clicks on one of its ads. We also offer AdWords on a cost-per-impression basis that enables advertisers to pay us based on the number of times their ads appear on our websites and our Google Network Members’ websites as specified by the advertisers. For advertisers using our AdWords cost-per-click pricing, we recognize as revenue the fees charged to advertisers each time a user clicks on one of the ads that appears next to the search results or content on our websites or our Google Network Members’ websites. For advertisers using our AdWords cost-per-impression pricing, we recognize as revenue the fees charged to advertisers each time their ads are displayed on our websites or our Google Network Members’ websites. Our AdWords agreements are generally terminable at any time by our advertisers.

Google AdSense refers to the online programs through which we distribute our advertisers’ AdWords ads for display on our Google Network Members’ websites, as well as programs to deliver ads on television broadcasts. Our AdSense programs include AdSense for search and AdSense for content.

AdSense for search is our online service for distributing relevant ads from our advertisers for display with search results on our Google Network Members’ websites. To use AdSense for search, most of our AdSense for search partners add Google search functionality to their web pages in the form of customizable Google search boxes. When visitors to these websites search either the website or the internet using these customizable search boxes, we display relevant ads on the search results pages, targeted to match user search queries. Ads shown through AdSense for search are text ads.

AdSense for content is our online service for distributing ads from our advertisers that are relevant to content on our Google Network Members’ websites. Under this program, we use automated technology to analyze the meaning of the content on the web page and serve relevant ads based on the meaning of such content. For example, a web page on an

 

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automotive blog that contains an entry about vintage cars might display ads for vintage car parts or vintage car shows. These ads are displayed in spaces that our AdSense for content partners have set aside on their websites. AdSense for content allows a variety of ad types to be shown, including text ads, image ads, Google Video Ads, link units (which are sets of clickable links to topic pages related to page content), themed units (which are regular text ads with graphic treatments that change seasonally and by geography), and gadget ads (which are customized “mini-sites” that run as ads on AdSense publisher websites).

For our online AdSense program, our advertisers pay us a fee each time a user clicks on one of our advertisers’ ads displayed on our Google Network Members’ websites or, for those advertisers who choose our cost-per-impression pricing, as their ads are displayed. To date, we have paid most of these advertiser fees to our Google Network Members, and we expect to continue doing so for the foreseeable future. We recognize these advertiser fees as revenue and the portion of the advertiser fee we pay to our Google Network Members as traffic acquisition costs under cost of revenues. Google Network Members do not pay any fees associated with the use of our AdSense program on their websites.

Our agreements with Google Network Members consist largely of uniform online “click-wrap” agreements that members enter into by interacting with our registration websites. The standard agreements have no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to share with the Google Network Member most of the advertiser fees generated by users clicking on ads on the Google Network Member’s website or, for advertisers who choose our cost-per-impression pricing, as the ads are displayed on the Google Network Member’s website. For example, under our standard agreements, we pay 51% and 68% of the fees collected from advertisers to our Google Network Members in AdSense for search and AdSense for content, respectively.

We have entered into arrangements with certain content providers under which we distribute or license their video and other content. Our agreements with content providers are typically standard agreements with no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to pay the content providers for the content we license. In a number of these arrangements, we display ads on the pages of our websites from which the content is viewed and share most of the fees these ads generate with the content providers. We recognize these advertiser fees as revenue and the fees we pay to our content providers as content acquisition costs under cost of revenues.

We believe the factors that influence the success of our advertising programs include the following:

 

   

The relevance, objectivity, and quality of our search results and the relevance and quality of ads displayed with each search results page.

 

   

The number of searches initiated at our websites and our Google Network Members’ websites and the underlying purpose of these searches (for instance, whether they are for academic research, to find a news article, or to find a product or service).

 

   

Our ability to increase traffic on our websites and our Google Network Members’ websites via new and improved ad formats, through devices other than personal computers, such as mobile devices and tablets.

 

   

The number and prominence of ads displayed on our websites and our Google Network Members’ websites.

 

   

The number of visits to, and the content of, our Google Network Members’ websites and certain of our websites and the relevance and quality of the ads we display next to this content.

 

   

The advertisers’ return on investment from advertising campaigns on our websites or our Google Network Members’ websites compared to other forms of advertising.

 

   

The total advertising spending budgets of each advertiser.

 

   

The number of advertisers and the breadth of items advertised.

 

   

The amount we ultimately pay our Google Network Members, distribution partners, and our content providers for traffic, access points, and content, compared to the amount of revenues we generate.

Motorola (Hardware and Other)

We generate revenues from our Motorola business through two segments. The Mobile segment designs, manufactures, sells and services wireless mobile devices, including smartphones and media tablets, with integrated software and accessory products, and licenses intellectual property. The Home segment designs, manufactures, sells, installs and services set-top boxes for digital and Internet protocol (IP) video, satellite and terrestrial broadcast networks, and Internet protocol television (IPTV) distribution systems, broadband access network infrastructure platforms, and associated software solutions to cable TV and telecommunication service providers.

 

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Trends in Our Business

Advertising transactions continue to shift from offline to online as the digital economy evolves. This has contributed to the rapid growth of our business since inception, resulting in substantially increased revenues, and we expect that our business will continue to grow. However, our revenue growth rate has generally declined over time, and it could do so in the future as a result of a number of factors, including increasing competition, our investments in new business strategies, products, services, and technologies, changes in our product mix, query growth rates and how users make queries, challenges in maintaining our growth rate as our revenues increase to higher levels, and increasing maturity of the online advertising market and other markets in which we participate. Mobile devices are also significant gateways to information now. We expect that our revenue growth rate will also be affected by evolving consumer preferences in this market, as well as advertising trends and the acceptance by mobile users of our products and services. In addition, if there is a further general economic downturn, this may result in fewer commercial queries by our users and may cause advertisers to reduce the amount they spend on online advertising, including the amount they are willing to pay for each click or impression, which could negatively affect the growth rate of our revenues. We plan to continue to invest aggressively in our core areas of strategic focus.

The main focus of our advertising programs is to provide relevant and useful advertising to our users, reflecting our commitment to constantly improve their overall web experience. As a result, we expect to continue to take steps to improve the relevance of the ads displayed on our websites and our Google Network Members’ websites. These steps include not displaying ads that generate low click-through rates or that send users to irrelevant or otherwise low quality websites and terminating our relationships with those Google Network Members whose websites do not meet our quality requirements. We may also continue to take steps to reduce the number of accidental clicks by our users. These steps could negatively affect the growth rate of our revenues.

Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenues, as well as aggregate paid click and average cost-per-click growth rates.

The operating margin we realize on revenues generated from ads placed on our Google Network Members’ websites through our AdSense program is significantly lower than the operating margin we realize from revenues generated from ads placed on our websites because most of the advertiser fees from ads served on Google Network Members’ websites are shared with our Google Network Members. For the past five years, growth in advertising revenues from our websites has generally exceeded that from our Google Network Members’ websites. This trend has had a positive impact on our operating margins, and we expect that this will continue for the foreseeable future, although the relative rate of growth in revenues from our websites compared to the rate of growth in revenues from our Google Network Members’ websites may vary over time. Also, the margins on advertising revenues from mobile devices and other newer advertising formats are generally lower than those from desktop computers and tablets. We expect this trend to continue in the near future.

We conduct our Motorola business in highly competitive markets, facing both new and established competitors. The markets for many of our products are characterized by rapidly changing technologies, frequent new product introductions, changing consumer trends, short product life cycles, consumer loyalty and evolving industry standards. Market disruptions caused by new technologies, the entry of new competitors, consolidations among our customers and competitors, changes in regulatory requirements, changes in economic conditions, supply chain interruptions or other factors, can introduce volatility into our businesses. Meeting all of these challenges requires consistent operational planning and execution and investment in technology, resulting in innovative products that meet the needs of our customers around the world.

From an overall business perspective, we continue to invest aggressively in our systems, data centers, corporate facilities, information technology infrastructure, and employees. We expect to increase our hiring in the remainder of 2012 and provide competitive compensation programs for our employees. Our full-time employee headcount was 28,768 at June 30, 2011 and 54,604 at June 30, 2012, which includes 20,293 headcount as a result of the acquisition of Motorola. Acquisitions will also remain an important component of our strategy and use of capital, and we expect our current pace of acquisitions to continue. We expect our cost of revenues will increase in dollars and may increase as a percentage of revenues in future periods, primarily as a result of forecasted increases in traffic acquisition costs, data center costs, content acquisition costs, credit card and other transaction fees, manufacturing and inventory-related costs, and other costs. In particular, traffic acquisition costs as a percentage of advertising revenues may increase in the future if we are unable to continue to improve the monetization or generation of revenues from traffic on our websites and our Google Network Members’ websites.

 

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As we expand our advertising programs and other products to international markets, we continue to increase our exposure to fluctuations in foreign currency to U.S. dollar exchange rates. We have a foreign exchange risk management program that is designed to reduce our exposure to fluctuations in foreign currency exchange rates. However, this program will not fully offset the effect of fluctuations on our revenues and earnings.

Results of Operations

We completed our acquisition of Motorola on May 22, 2012 (the acquisition date). The operating results of Motorola were included in our Consolidated Statement of Income from the acquisition date through June 30, 2012.

The following table presents our historical operating results as a percentage of our revenues for the periods indicated:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Consolidated Statements of Income Data:

        

Revenues:

        

Google (advertising and other)

     100.0     89.8     100.0     94.5

Motorola (hardware and other)

     0        10.2        0        5.5   

Costs and expenses:

        

Cost of revenues – Google (advertising and other)

     35.1        32.6        34.7        34.0   

Cost of revenues – Motorola (hardware and other)

     0        8.4        0        4.5   

Research and development

     13.7        13.0        14.0        13.2   

Sales and marketing

     12.1        11.7        12.0        11.8   

General and administrative

     7.2        8.1        7.1        7.7   

Charge related to resolution of Department of Justice investigation

     0        0        2.8        0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total costs and expenses

     68.1        73.8        70.6        71.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     31.9        26.2        29.4        28.8   

Interest and other income, net

     2.3        2.1        1.7        1.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     34.2        28.3        31.1        30.6   

Provision for income taxes

     6.4        5.5        6.6        5.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     27.8     22.8     24.5     24.8
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Revenues

The following table presents our revenues, by revenue source, for the periods presented (in millions):

 

     Three Months Ended
June 30
     Six Months Ended
June 30,
 
     2011      2012      2011      2012  
     (unaudited)  

Google:

           

Advertising revenues:

           

Google websites

   $ 6,232       $ 7,542       $ 12,111       $ 14,854   

Google Network Members’ websites

     2,484         2,983         4,911         5,896   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total advertising revenues

     8,716         10,525         17,022         20,750   

Other revenues

     310         439         580         859   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Google revenues (advertising and other)

     9,026         10,964         17,602         21,609   

Motorola:

           

Total Motorola revenues (hardware and other)

     0         1,250         0         1,250   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

   $ 9,026       $ 12,214       $ 17,602       $ 22,859   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table presents our revenues, by business, as a percentage of total revenues for the periods presented:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Google (advertising and other)

     100     90     100     95

Motorola (hardware and other)

     0        10        0        5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     100     100     100     100
  

 

 

   

 

 

   

 

 

   

 

 

 

The following table presents our Google revenues, by revenue source, as a percentage of total Google revenues for the periods presented:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Advertising revenues:

        

Google websites

     69     69     69     69

Google Network Members’ websites

     28        27        28        27   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total advertising revenues

     97        96        97        96   

Google websites as % of advertising revenues

     72        72        71        72   

Google Network Members’ websites as % of advertising revenues

     28        28        29        28   

Other revenues

     3     4     3     4

Our revenues increased $3,188 million and $5,257 million from the three and six months ended June 30, 2011 to the three and six months ended June 30, 2012. These increases resulted primarily from an increase in advertising revenues generated by Google websites of $1,310 million and $2,743 million for the three and six months ended June 30, 2012. In addition, the increases were attributed to an increase in advertising revenues generated by Google Network Members’ websites of $499 million and $985 million. The increase in advertising revenues for Google websites and Google Network Members’ websites resulted primarily from an increase in the number of paid clicks through our advertising programs, partially offset by a decrease in the average cost-per-click paid by our advertisers. The increase in the number of paid clicks generated through our advertising programs was due to an increase in aggregate traffic, certain monetization improvements including new ad formats, the continued global expansion of our products, advertisers, and user base, as well as an increase in the number of Google Network Members. The decrease in the average cost-per-click paid by our advertisers was driven by various factors, such as the general strengthening of the U.S dollar compared to certain foreign currencies (primarily the Euro), the changes in platform mix due to traffic growth in

 

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mobile devices, where the average cost-per-click is typically lower compared to desktop computers and tablets, and the changes in geographical mix due to traffic growth in emerging markets, where the average cost-per-click is typically lower compared to more mature markets.

In addition, the increase in our revenues from the three and six months ended June 30, 2011 to the three and six months ended June 30, 2012 resulted from the inclusion of revenues from our Motorola business of $1.3 billion, of which $843 million was from the Mobile segment and $407 million from the Home segment.

Improvements in our ability to ultimately monetize increased traffic primarily relate to enhancing the end user experience, including providing end users with ads that are more relevant to their search queries or to the content on the Google Network Members’ websites they visit. For instance, these improvements include increasing site links to be full size links with the URL (uniform resource locator), moving a portion of the first line of the ad to the heading to better promote the content of the ad, providing an option to preview the ad, and moving the ad’s URL to a separate line below the heading for greater page format consistency.

Aggregate paid clicks on Google websites and Google Network Members’ websites increased approximately 42% from the three months ended June 30, 2011 to the three months ended June 30, 2012 and 40% from the six months ended June 30, 2011 to the six months ended June 30, 2012. Average cost-per-click on Google websites and Google Network Members’ websites decreased approximately 16% from the three months ended June 30, 2011 to the three months ended June 30, 2012 and 14% from the six months ended June 30, 2011 to the six months ended June 30, 2012. The rate of change in aggregate paid clicks and average cost-per-click, and their correlation with the rate of change in revenues, has fluctuated and may fluctuate in the future because of various factors, including the revenue growth rates on our websites compared to those of our Google Network Members, advertiser competition for keywords, changes in foreign currency exchange rates, seasonality, the fees advertisers are willing to pay based on how they manage their advertising costs, changes in advertising quality or formats, and general economic conditions. In addition, traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels, including mobile devices, also contributes to these fluctuations. Changes in aggregate paid clicks and average cost-per-click may not be indicative of our performance or advertiser experiences in any specific geographic market, vertical, or industry.

We believe that the increase in the number of paid clicks on Google websites and Google Network Members’ websites is substantially the result of our commitment to improving the relevance and quality of both our search results and the advertisements displayed, which we believe results in a better user experience, which in turn results in more searches, advertisers, and Google Network Members and other partners.

Revenues by Geography

The following table presents our Google domestic and international revenues as a percentage of Google revenues, determined based on the billing addresses of our customers for our Google business:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

United States

     46     46     46     46

United Kingdom

     11     11     11     11

Rest of the world

     43     43     43     43

 

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The following table presents our consolidated domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers for our Google business, and shipping addresses of our customers for our Motorola business:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

United States

     46     47     46     46

United Kingdom

     11     10     11     10

Rest of the world

     43     43     43     44

The general strengthening of the U.S. dollar relative to certain foreign currencies (primarily the Euro) from the three months ended June 30, 2011 to the three months ended June 30, 2012 had an unfavorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $30 million, or 2.6%, higher and our revenues from the rest of the world would have been approximately $349 million, or 6.6%, higher in the three months ended June 30, 2012. This is before consideration of hedging gains of $7 million and $74 million recognized to revenues from the United Kingdom and the rest of the world in the three months ended June 30, 2012.

The general strengthening of the U.S. dollar relative to certain foreign currencies (primarily the Euro) from the six months ended June 30, 2011 to the six months ended June 30, 2012 had an unfavorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $26 million, or 1.1%, higher and our revenues from the rest of the world would have been approximately $420 million, or 4.3%, higher in the six months ended June 30, 2012. This is before consideration of hedging gains of $11 million and $107 million recognized to revenues from the United Kingdom and the rest of the world in the six months ended June 30, 2012.

Although we expect to continue to make investments in international markets, these investments may not result in an increase in our international revenues as a percentage of total revenues in 2012 or thereafter. See Note 14 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information about geographic areas.

Costs and Expenses

Cost of Revenues

Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts ultimately paid to our Google Network Members under AdSense arrangements and to certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points) or otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share and fixed fee arrangements with our Google Network Members and distribution partners.

Certain distribution arrangements require us to pay our partners based on a fee per access point delivered and not exclusively—or at all—based on revenue share. These fees are non-refundable. Further, these arrangements are terminable at will, although under the terms of certain contracts we or our distribution partners may be subject to penalties in the event of early termination. We recognize fees under these arrangements over the estimated useful lives of the access points (approximately two years) to the extent we can reasonably estimate those lives and they are longer than one year, or based on any contractual revenue share, if greater. Otherwise, the fees are charged to expense as incurred. The estimated useful life of the access points is based on the historical average period of time they generate traffic and revenues.

Cost of revenues also includes the expenses associated with the operation of our data centers, including depreciation, labor, energy, and bandwidth costs, amortization of acquired intangible assets, credit card and other transaction fees related to processing customer transactions, manufacturing and inventory-related costs, as well as content acquisition costs. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. In a number of these arrangements, we display ads on the pages of our websites from which the content is viewed and share most of the fees these ads generate with the content providers. To the extent we are obligated to make guaranteed minimum revenue share payments to our content providers, we recognize as content acquisition costs the contractual revenue share amount or on a straight-line basis, whichever is greater, over the terms of the agreements.

 

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The following tables present our cost of revenues and cost of revenues as a percentage of revenues by business, and our traffic acquisition costs and traffic acquisition costs as a percentage of advertising revenues in the Google business, for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Cost of revenues – Google (advertising and other)

   $ 3,172      $ 3,984      $ 6,107      $ 7,773   

Cost of revenues – Motorola (hardware and other)

     0        1,029        0        1,029   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of revenues

   $ 3,172      $ 5,013      $ 6,107      $ 8,802   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of revenues – Google (advertising and other) as a percentage of Google revenues

     35.1     36.3     34.7     36.0

Cost of revenues – Motorola (hardware and other) as a percentage of Motorola revenues

     0        82.3     0        82.3

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Traffic acquisition costs related to AdSense arrangements

   $ 1,755      $ 2,093      $ 3,455      $ 4,135   

Traffic acquisition costs related to distribution arrangements

     355        507        693        975   
  

 

 

   

 

 

   

 

 

   

 

 

 

Traffic acquisition costs

   $ 2,110      $ 2,600      $ 4,148      $ 5,110   
  

 

 

   

 

 

   

 

 

   

 

 

 

Traffic acquisition costs as a percentage of advertising revenues in the Google business

     24.2     24.7     24.4     24.6

Cost of revenues increased $1,841 million from the three months ended June 30, 2011 to the three months ended June 30, 2012. The increase was primarily related to the inclusion of cost of revenues from our Motorola business of $1,029 million. Additionally, there was an increase in traffic acquisition costs of $338 million resulting from more advertiser fees generated through our AdSense program and an increase in traffic acquisition costs of $152 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. In addition, there was an increase in data center costs of $152 million primarily resulting from the depreciation of additional information technology assets and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $91 million primarily related to content displayed on YouTube.

Cost of revenues increased $2,695 million from the six months ended June 30, 2011 to the six months ended June 30, 2012. The increase was primarily related to the inclusion of cost of revenues from our Motorola business of $1,029 million. Additionally, there was an increase in traffic acquisition costs of $680 million resulting from more advertiser fees generated through our AdSense program and an increase in traffic acquisition costs of $282 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. In addition, there was an increase in data center costs of $399 million primarily resulting from the depreciation of additional information technology assets and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $173 million primarily related to content displayed on YouTube.

We expect cost of revenues will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2012 and in future periods, primarily as a result of forecasted increases in traffic acquisition costs, data center costs, manufacturing and inventory-related costs, content acquisition costs, credit card and other transaction fees, and other costs. Traffic acquisition costs as a percentage of advertising revenues may fluctuate in the future based on a number of factors, including the following:

 

   

The relative growth rates of revenues from our websites and from our Google Network Members’ websites.

 

   

Whether we are able to enter into more AdSense arrangements that provide for lower revenue share obligations or whether increased competition for arrangements with existing and potential Google Network Members results in less favorable revenue share arrangements.

 

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Whether we are able to continue to improve the monetization of traffic on our websites and our Google Network Members’ websites.

 

   

The relative growth rates of expenses associated with distribution arrangements and the related revenues generated, including whether we share with certain existing and new distribution partners proportionately more of the aggregate advertising fees that we earn from paid clicks derived from search queries these partners direct to our websites.

Research and Development

The following table presents our research and development expenses, and research and development expenses as a percentage of revenues, for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Research and development expenses

   $ 1,234      $ 1,585      $ 2,456      $ 3,026   

Research and development expenses as a percentage of revenues

     13.7     13.0     14.0     13.2

Research and development expenses consist primarily of compensation and related costs for personnel responsible for the research and development of new and existing products and services. We expense research and development costs as incurred.

Research and development expenses increased $351 million from the three months ended June 30, 2011 to the three months ended June 30, 2012, which includes $143 million related to Motorola. The remaining increase of $208 million was primarily due to an increase in labor and facilities-related costs of $112 million, largely as a result of a 13% increase in research and development headcount. In addition, there was an increase in stock-based compensation expense of $32 million.

Research and development expenses increased $570 million from the six months ended June 30, 2011 to the six months ended June 30, 2012, which includes $143 million related to Motorola. The remaining increase of $427 million was primarily due to an increase in labor and facilities-related costs of $208 million, largely as a result of a 13% increase in research and development headcount. In addition, there was an increase in stock-based compensation expense of $94 million.

We expect that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2012 and in future periods because we expect to continue to invest in building necessary employee and systems infrastructures required to support the development of new, and improve existing, products and services.

Sales and Marketing

The following table presents our sales and marketing expenses, and sales and marketing expenses as a percentage of revenues, for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Sales and marketing expenses

   $ 1,091      $ 1,433      $ 2,117      $ 2,702   

Sales and marketing expenses as a percentage of revenues

     12.1     11.7     12.0     11.8

Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in customer service, sales, and sales support functions, as well as advertising and promotional expenditures.

 

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Sales and marketing expenses increased $342 million from the three months ended June 30, 2011 to the three months ended June 30, 2012, which includes $147 million related to Motorola. The remaining increase of $195 million was primarily due to an increase in labor and facilities-related costs of $112 million, largely as a result of an 18% increase in sales and marketing headcount, as well as an increase in advertising and promotional expenses of $39 million. In addition, there was an increase in stock-based compensation expense of $27 million.

Sales and marketing expenses increased $585 million from the six months ended June 30, 2011 to the six months ended June 30, 2012, which includes $147 million related to Motorola. The remaining increase of $438 million was primarily due to an increase in labor and facilities-related costs of $227 million, largely as a result of an 18% increase in sales and marketing headcount, as well as an increase in advertising and promotional expenses of $117 million. In addition, there was an increase in stock-based compensation expense of $46 million.

We expect that sales and marketing expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2012 and in future periods, as we expand our business globally, increase advertising and promotional expenditures in connection with new and existing products, and increase the level of service we provide to our advertisers, Google Network Members, and other partners.

General and Administrative

The following table presents our general and administrative expenses, and general and administrative expenses as a percentage of revenues, for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

General and administrative expenses

   $ 648      $ 980      $ 1,244      $ 1,737   

General and administrative expenses as a percentage of revenues

     7.2     8.1     7.1     7.7

General and administrative expenses consist primarily of compensation and related costs for personnel and facilities, and include costs related to our facilities, finance, human resources, information technology, and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit, information technology consulting, and outsourcing services.

General and administrative expenses increased $332 million from the three months ended June 30, 2011 to the three months ended June 30, 2012, which includes $164 million related to Motorola, of which $119 million was a charge related to severance and benefit arrangements. The remaining increase of $168 million was primarily due to an increase in fees for professional services of $63 million, the majority of which was related to legal costs, as well as an increase in amortization of intangible assets of $48 million. In addition, there was an increase in stock-based compensation expense of $28 million.

General and administrative expenses increased $493 million from the six months ended June 30, 2011 to the six months ended June 30, 2012, which includes $164 million related to Motorola, of which $119 million was a charge related to severance and benefit arrangements. The remaining increase of $329 million was primarily due to an increase in fees for professional services of $105 million, the majority of which was related to legal costs, an increase in labor and facilities-related costs of $68 million, primarily as a result of a 22% increase in general and administrative headcount, as well as an increase in amortization of intangible assets of $63 million. In addition, there was an increase in stock-based compensation expense of $46 million.

As we expand our business and incur additional expenses, we expect general and administrative expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2012 and in future periods.

Charge Related to the Resolution of Department of Justice Investigation

In connection with a resolution of an investigation by the United States Department of Justice into the use of Google advertising by certain advertisers, we accrued $500 million during the first quarter of 2011, which was paid in August 2011 upon final resolution of that matter.

 

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Stock-Based Compensation

The following table presents our stock-based compensation, and stock-based compensation as a percentage of revenues, for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Stock-based compensation

   $ 435      $ 658      $ 866      $ 1,214   

Stock-based compensation as a percentage of revenues

     4.8     5.4     4.9     5.3

Stock-based compensation increased $223 million and $348 million from the three and six months ended June 30, 2011 to the three and six months ended June 30, 2012. This increase was primarily due to additional stock awards issued to existing and new employees, as well as awards issued in connection with the acquisition of Motorola.

We estimate stock-based compensation to be approximately $2.6 billion in 2012 and $4.7 billion thereafter. This estimate does not include expenses to be recognized related to employee stock awards that are granted after June 30, 2012 or non-employee stock awards that have been or may be granted. In addition, to the extent forfeiture rates are different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations.

 

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Interest and Other Income, Net

Interest and other income, net, increased $50 million from the three months ended June 30, 2011 to the three months ended June 30, 2012. This increase was primarily driven by a gain on divestiture of business of $188 million, partially offset by an increase in foreign currency exchange loss of $77 million, a decrease in interest income of $32 million, and a decrease in realized gains on investments of $20 million.

Interest and other income, net, increased $110 million from the six months ended June 30, 2011 to the six months ended June 30, 2012. This increase was primarily driven by a gain on divestiture of business of $188 million, an increase in realized gains on investments of $73 million, partially offset by an increase in foreign currency exchange loss of $92 million, a decrease in interest income of $40 million, and an increase in interest expenses of $25 million.

The costs of our foreign exchange hedging activities that we recognized to interest and other income, net, are primarily a function of the notional amount of the option and forward contracts and their related duration, and the movement of the foreign exchange rates relative to the strike prices of the contracts, as well as the volatility of the foreign exchange rates.

As we expand our international business, we believe costs related to hedging activities under our foreign exchange risk management program may increase in dollar amount in the remainder of 2012 and in future periods.

Provision for Income Taxes

The following table presents our provision for income taxes, and the effective tax rate for the periods presented (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2012     2011     2012  
     (unaudited)  

Provision for income taxes

   $ 580      $ 672      $ 1,174      $ 1,327   

Effective tax rate

     18.8     19.4     21.4     19.0

Our provision for income taxes increased from the three months ended June 30, 2011 to the three months ended June 30, 2012, primarily as a result of increases in federal income taxes, driven by higher taxable income year over year. Our effective tax rate increased from the three months ended June 30, 2011 to the three months ended June 30, 2012, primarily as a result of the expiration of Federal research credit in 2011.

Our provision for income taxes increased from the six months ended June 30, 2011 to the six months ended June 30, 2012, primarily as a result of increases in federal income taxes, driven by higher taxable income year over year. Our effective tax rate decreased from the six months ended June 30, 2011 to the six months ended June 30, 2012, primarily as a result of a discrete item recognized related to an investigation by the Department of Justice in the three months ended March 31, 2011.

Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

 

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Liquidity and Capital Resources

In summary, our cash flows were as follows (in millions):

 

     Six Months Ended
June 30,
 
     2011     2012  
     (unaudited)  

Net cash provided by operating activities

   $ 6,691      $ 7,946   

Net cash used in investing activities

     (11,035     (4,235

Net cash provided by financing activities

     847        1,869   

At June 30, 2012, we had $43.1 billion of cash, cash equivalents, and marketable securities. Cash equivalents and marketable securities are comprised of time deposits, money market and other funds, including cash collateral received related to our securities lending program, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments and municipalities in the U.S., corporate securities, and mortgage-backed securities.

As of June 30, 2012, $27.3 billion of the $43.1 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations.

Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. At June 30, 2012, we had unused letters of credit for approximately $39 million. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Our liquidity could be negatively affected by a decrease in demand for our products and services. In addition, we may make acquisitions or license products and technologies complementary to our business and may need to raise additional capital through future debt or equity financing to provide for greater flexibility to fund any such acquisitions and licensing activities. Additional financing may not be available at all or on terms favorable to us.

We have established a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from the commercial paper program are used for general corporate purposes. As of June 30, 2012, we had $2.8 billion of outstanding commercial paper recorded as short-term debt, with a weighted-average interest rate of 0.1% that matures at various dates through September 2012. Average commercial paper borrowings during the three months ended June 30, 2012 were $2.5 billion, and the maximum amount of commercial paper borrowings outstanding during the three months ended June 30, 2012 was $2.8 billion. In conjunction with this program, we established a $3.0 billion revolving credit facility expiring in July 2016. Interest rate for the credit facility is determined based on a formula using certain market rates. As of June 30, 2012, we were in compliance with the financial covenant in this credit facility and no amounts were outstanding.

Additionally, as of June 30, 2012, we had a $468 million secured promissory note outstanding recorded as short-term debt, with an interest rate of 1.0% that matures in December 2012.

In May 2011, we issued $3.0 billion of unsecured senior notes in three equal tranches, due in 2014, 2016, and 2021, with stated interest rates of 1.25%, 2.125%, and 3.625%. The net proceeds from the sale of the notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. As of June 30, 2012, the total carrying value and estimated fair value of these notes were $3.0 billion and $3.2 billion. The estimated fair value was based on quoted prices for our publicly-traded debt as of June 30, 2012. We are not subject to any financial covenants under the notes.

Cash Provided by Operating Activities

Cash provided by operating activities consists of net income adjusted for certain non-cash items, primarily including amortization, depreciation, deferred income taxes, excess tax benefits from stock-based award activities, and stock-based compensation expense, as well as gain on divestiture of business and the effect of changes in working capital and other activities.

Cash provided by operating activities in the six months ended June 30, 2012 was $7,946 million and consisted of net income of $5,675 million, adjustments for non-cash items of $2,099 million, a gain on divestiture of business of $188 million and cash used in working capital and other activities of $16 million. Adjustments for non-cash items primarily consisted of $1,214 million of stock-based compensation expense, $851 million of depreciation and amortization expense on property and equipment, $330 million of amortization

 

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of intangible and other assets, and $191 million of deferred income taxes. In addition, the decrease in cash from changes in working capital activities primarily consisted of an increase in prepaid revenue share, expenses, and other assets of $1,188 million and a decrease in accrued expenses and other liabilities of $243 million. These decreases were partially offset by a net increase in income taxes payable and deferred income taxes of $1,169 million and a decrease in inventories of $170 million.

Cash provided by operating activities in the six months ended June 30, 2011 was $6,691 million and consisted of net income of $4,304 million, adjustments for non-cash items of $2,208 million, and cash provided by working capital and other activities of $179 million. Adjustments for non-cash items primarily consisted of $866 million of stock-based compensation expense, $648 million of depreciation and amortization expense on property and equipment, $464 million of deferred income taxes, and $208 million of amortization of intangible and other assets. In addition, the increase in cash from changes in working capital activities primarily consisted of an increase in accrued expenses and other liabilities of $297 million primarily due to a charge recorded related to a potential resolution of an investigation by the Department of Justice, an increase in accounts payable of $77 million primarily a result of the growth of our business, and an increase in deferred revenue of $69 million. These increases were partially offset by an increase in prepaid revenue share, expenses and other assets of $148 million and a net decrease in income taxes payable and deferred income taxes of $98 million. The decrease in income taxes payable and deferred income taxes reflected primarily increased estimated income taxes paid during the second quarter of 2011 with respect to the year ended December 31 2011, partially offset by additional tax obligations accrued.

As we expand our business internationally, we have offered payment terms to certain advertisers that are standard in their locales but longer than terms we would generally offer to our domestic advertisers. This may increase our working capital requirements and may have a negative effect on cash provided by our operating activities.

Cash Used In Investing Activities

Cash used in investing activities in the six months ended June 30, 2012 of $4,235 million was primarily attributable to $12.4 billion paid in connection with the acquisition of Motorola, net of $2.9 billion of cash acquired, and capital expenditures of $1,381 million related primarily to our facilities, data centers, and related equipment. These decreases were partially offset by net maturities and sales of marketable securities of $7,115 million. Also, in connection with our securities lending program, there was a decrease in investments in reverse repurchase agreements of $270 million and a cash collateral return of $91 million.

Cash used in investing activities in the six months ended June 30, 2011 of $11.0 billion was primarily attributable to net purchases of marketable securities of $7,328 million, capital expenditures of $1,807 million related principally to our facilities, data centers and related equipment, and cash consideration used in acquisitions and other investments of $1,206 million, including $676 million paid in connection with the acquisition of ITA. Also, in connection with our securities lending program, we returned $424 million of cash collateral and invested $270 million in certain reverse repurchase agreements.

In order to manage expected increases in internet traffic, advertising transactions, and new products and services, and to support our overall global business expansion, we expect to make significant investments in our systems, data centers, corporate facilities, and information technology infrastructure in the remainder of 2012 and thereafter. However, the amount of our capital expenditures has fluctuated and may continue to fluctuate on a quarterly basis.

In addition, we expect to spend a significant amount of cash on acquisitions and other investments from time to time. These acquisitions generally enhance the breadth and depth of our expertise in engineering and other functional areas, our technologies, and our product offerings.

Cash Provided by Financing Activities

Cash provided by financing activities in the six months ended June 30, 2012 of $1,869 million was primarily driven by net proceeds of $1,998 million from short-term debt issued under our commercial paper program. This was partially offset by net payments for stock-based award activities of $184 million.

Cash provided by financing activities in the six months ended June 30, 2011 of $847 million was primarily driven by net proceeds of $726 million of debt issued and stock-based award activities of $88 million.

 

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Contractual Obligations

We recorded long-term taxes payable of $205 million in the six months ended June 30, 2012 related to tax positions for which the timing of the ultimate resolution is uncertain. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. (U.S. GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors.

Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.

Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

Our effective tax rates have differed from the statutory rate primarily due to the tax impact of foreign operations, state taxes, certain benefits realized related to stock award activities, and research and experimentation tax credits. The effective tax rates were 18.8% and 19.4% for the three months ended June 30, 2011 and 2012 and 21.4% and 19.0% for the six months ended June 30, 2011 and 2012. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Loss Contingencies

We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, tax, labor and employment disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred, and the amount can be reasonably estimated. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 11 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information regarding contingencies.

 

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Stock-Based Compensation

Our stock-based compensation expense is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes-Merton (BSM) option pricing model and is recognized as expense over the requisite service period. The BSM model requires various highly judgmental assumptions including expected volatility and expected term. If any of the assumptions used in the BSM model changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience and our expectations regarding future pre-vesting termination behavior of employees. To the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly.

Available Information

Our website is located at www.google.com, and our investor relations website is located at http://investor.google.com. The following filings are available through our investor relations website after we file them with the SEC: Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements for our annual meetings of stockholders, for the last three years. These filings are also available for download free of charge on our investor relations website. We also provide a link to the section of the SEC’s website at www.sec.gov that has all of our public filings, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports, our Proxy Statements, and other ownership related filings. Further, a copy of this Quarterly Report on Form 10-Q is located at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.

We webcast our earnings calls and certain events we participate in or host with members of the investment community on our investor relations website. Additionally, we provide notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases, and blogs as part of our investor relations website. Investors and others can receive notifications of new information posted on our investor relations website in real time by signing up for email alerts and RSS feeds. Further corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading “Corporate Governance.” The contents of our websites are not intended to be incorporated by reference into this Quarterly Report on Form 10-Q or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to financial market risks, including changes in currency exchange rates and interest rates.

Foreign Currency Exchange Risk

Economic Exposure

We transact business in various foreign currencies and have significant international revenues, as well as costs denominated in foreign currencies. This exposes us to the risk of fluctuations in foreign currency exchange rates. We purchase foreign exchange option contracts to reduce the volatility of cash flows related to forecasted revenues denominated in certain foreign currencies. The objective of the foreign exchange contracts is to better ensure that the U.S. dollar-equivalent cash flows are not adversely affected by changes in the U.S. dollar/foreign currency exchange rates. These contracts are designated as cash flow hedges. The gain on the effective portion of a cash flow hedge is initially reported as a component of AOCI and subsequently reclassified into revenues when the hedged revenues are recorded or as interest and other income, net, if the hedged transaction becomes probable of not occurring. Any gain after a hedge is de-designated or related to an ineffective portion of a hedge is recognized as interest and other income, net, immediately.

At December 31, 2011, the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with Euros were 2.8 billion (or approximately $3.8 billion) and $232 million; the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with British pounds were £1.4 billion (or approximately $2.2 billion) and $80 million; and the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with Canadian dollars were C$504 million (or approximately $490 million) and $17 million. At June 30, 2012, the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with Euros were 3.8 billion (or approximately $4.9 billion) and $303 million; the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with British pounds were £1.7 billion (or approximately $2.6 billion) and $73 million; and the notional principal and fair value of foreign exchange contracts to purchase U.S. dollars with Canadian dollars were C$615 million (or approximately $591 million) and $14 million. These foreign exchange option contracts have maturities of 36 months or less. We may enter into similar contracts in other foreign currencies in the future.

We considered the historical trends in currency exchange rates and determined that it was reasonably possible that changes in exchange rates of 20% for our foreign currencies instruments could be experienced in the near term.

If the U.S. dollar weakened by 20%, the amount recorded in AOCI before tax effect would have been approximately $244 million lower at June 30, 2012, and the total amount of expense recorded as interest and other income, net, would have been approximately $103 million higher in the three months ended June 30, 2012. If the U.S. dollar strengthened by 20%, the amount recorded in AOCI before tax effect would have been approximately $1.5 billion higher at June 30, 2012, and the total amount of expense recorded as interest and other income, net, would have been approximately $161 million higher in the three months ended June 30, 2012.

Transaction Exposure

Our exposure to foreign currency transaction gains and losses is the result of certain net receivables due from our foreign subsidiaries and customers being denominated in currencies other than the functional currency of the subsidiary, primarily the Euro and the British pound. Our foreign subsidiaries primarily conduct their businesses in local currency. We have entered into foreign exchange contracts to offset the foreign exchange risk on certain monetary assets and liabilities denominated in currencies other than the local currency of the subsidiary.

The notional principal of foreign exchange contracts to purchase U.S. dollars with foreign currencies was $2.3 billion and $3.1 billion at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to sell U.S. dollars for foreign currencies was $472 million and $453 million at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to purchase Euros with other foreign currencies was 711 million (or approximately $929 million) and 786 million (or approximately $979 million) at December 31, 2011 and June 30, 2012. The notional principal of foreign exchange contracts to sell Euros for other foreign currencies was 10 million (or approximately $12 million) at June 30, 2012 and no such contracts were outstanding at December 31, 2011.

We considered the historical trends in currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 20% for all currencies could be experienced in the near term. These changes would have resulted in an adverse impact on income before income taxes of approximately $27 million and $38 million at December 31, 2011 and June 30, 2012. The adverse impact at December 31, 2011 and June 30, 2012 is after consideration of the offsetting effect of approximately $503 million and $635 million from foreign exchange contracts in

 

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place for the months of December 2011 and June 2012. These reasonably possible adverse changes in exchange rates of 20% were applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates to compute the adverse impact these changes would have had on our income before income taxes in the near term.

Interest Rate Risk

We invest our excess cash primarily in highly liquid debt instruments of the U.S. government and its agencies, municipalities in the U.S., debt instruments issued by foreign governments, time deposits, money market and other funds, mortgage-backed securities, and corporate debt securities. By policy, we limit the amount of credit exposure to any one issuer.

Investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Due in part to these factors, our income from investments may decrease in the future. However, we use certain interest rate derivative contracts to hedge interest rate risk of our fixed income securities.

During the second quarter of 2012, we began to hedge the variability of forecasted interest payments using forward-starting interest swaps. The total notional amount of these swaps was $1.0 billion as of June 30, 2012, with terms calling for us to receive interest at a variable rate and to pay interest at a fixed rate. These forward-starting interest swaps effectively fix the benchmark interest rate on an anticipated debt issuance of $1.0 billion in 2014, and they will be terminated upon issuance of the debt.

When entering into forward-starting interest rate swaps, we are subject to market risk with respect to changes in the underlying benchmark interest rate that impacts the fair value of the forward-starting interest swaps. We manage market risk by matching the terms of the swaps with the critical terms of the expected debt issuance.

We considered the historical volatility of interest rates and determined that it was reasonably possible that an adverse change of 100 basis points could be experienced in the near term. A hypothetical 1.00% (100 basis points) increase in interest rates would have resulted in a decrease in the fair values of our marketable securities of approximately $934 million and $860 million at December 31, 2011 and June 30, 2012, after taking into consideration of the offsetting effect from interest rate derivative contracts outstanding as of December 31, 2011 and June 30, 2012. A hypothetical 1.00% (100 basis points) decrease in interest rates would have resulted in a decrease in the fair values of our forward-starting interest swaps of approximately $106 million at June 30, 2012.

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q.

Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of June 30, 2012, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations on Effectiveness of Controls and Procedures

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

 

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PART II—OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

For a description of our material pending legal proceedings, please refer to Note 11 “Contingencies—Legal Matters” of the Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

 

ITEM 1A. RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties, including those described below, which could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our Class A common stock.

Risks Related to Our Business and Industry

We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected.

Our business is rapidly evolving and intensely competitive, and is subject to changing technologies, shifting user needs, and frequent introductions of new products and services. Our ability to compete successfully depends heavily on providing products and services that make using the internet a more useful and enjoyable experience for our users and delivering innovative products and technologies to the marketplace. With our acquisition of Motorola, the competitive pressure to innovate will now encompass a wider range of products and services, including products and services that may be outside of our historical core business.

We have many competitors in different industries, including general purpose search engines, vertical search engines and e-commerce sites, social networking sites, traditional media companies, wireless mobile device companies, and providers of online products and services. Our current and potential competitors range from large and established companies to emerging start-ups. Established companies have longer operating histories and more established relationships with customers and users, and they can use their experience and resources in ways that could affect our competitive position, including by making acquisitions, investing aggressively in research and development, aggressively initiating intellectual property claims (whether or not meritorious) and competing aggressively for advertisers and websites. Emerging start-ups may be able to innovate and provide products and services faster than we can.

Our competitors are constantly developing innovations in web search, online advertising, wireless mobile devices, and web-based products and services. The research and development of new, technologically advanced products is also a complex and uncertain process requiring high levels of innovation and investment, as well as the accurate anticipation of technology, market trends and consumer needs. As a result, we must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our web search technology and our existing products and services, and introduce new products and services that people can easily and effectively use. If we are unable to provide quality products and services, then acceptance rates for our products and services could decline and affect consumer and advertiser perceptions of our brand. In addition, these new products and services may present new and difficult technological and legal challenges, and we may be subject to claims if users of these offerings experience service disruptions or failures or other issues. Our operating results would also suffer if our innovations are not responsive to the needs of our users, advertisers, and Google Network Members, are not appropriately timed with market opportunities, or are not effectively brought to market. As technology continues to develop, our competitors may be able to offer user experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, and content providers, our revenues and operating results could be adversely affected.

Our ongoing investment in new business strategies and new products, services, and technologies is inherently risky, and could disrupt our ongoing businesses.

We have invested and expect to continue to invest in new business strategies, products, services, and technologies. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, insufficient revenues to offset liabilities assumed and expenses associated with these new

 

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investments, inadequate return of capital on our investments, and unidentified issues not discovered in our due diligence of such strategies and offerings. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not adversely affect our reputation, financial condition, and operating results.

Acquisitions and investments could result in operating difficulties, dilution, and other harmful consequences that may adversely impact our business and results of operations.

Acquisitions are an important element of our overall corporate strategy and use of capital, and we expect our current pace of acquisitions to continue. These transactions could be material to our financial condition and results of operations. We also expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions. The process of integrating an acquired company, business, or technology has created, and will continue to create, unforeseen operating difficulties and expenditures. The areas where we face risks include:

 

   

Diversion of management time and focus from operating our business to acquisition integration challenges.

 

   

Implementation or remediation of controls, procedures, and policies at the acquired company.

 

   

Integration of the acquired company’s accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions.

 

   

Transition of operations, users, and customers onto our existing platforms.

 

   

Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval, under competition and antitrust laws which could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition.

 

   

In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries.

 

   

Failure to successfully further develop the acquired business or technology.

 

   

Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire.

 

   

Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities.

 

   

Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties.

Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and investments could cause us to fail to realize the anticipated benefits of such acquisitions or investments, incur unanticipated liabilities, and harm our business generally.

Future acquisitions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or write-offs of goodwill, any of which could harm our financial condition or results. Also, the anticipated benefit of many of our acquisitions may not materialize.

We generate a significant portion of our revenues from advertising, and the reduction in spending by or loss of advertisers could seriously harm our business.

We generated 96% of Google revenues from our advertisers in 2011 and in the six months ended June 30, 2012. Following our acquisition of Motorola, we still expect a significant portion of our revenues to come from advertising. Our advertisers can generally terminate their contracts with us at any time. Advertisers will not continue to do business with us if their investment in advertising with us does not generate sales leads, and ultimately customers, or if we do not deliver their advertisements in an appropriate and effective manner. If we are unable to remain competitive and provide value to our advertisers, they may stop placing ads with us, which would adversely affect our revenues and business.

 

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In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative impact on the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could adversely affect our revenues and business.

Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future.

Our revenue growth rate could decline over time as a result of a number of factors, including increasing competition, changes in our product mix, query growth rates and how users make queries, the challenges in maintaining our growth rate as our revenues increase to higher levels, the increasing maturity of the online advertising market and the other markets in which we participate and the success of our investments in new business strategies, products, services, and technologies, such as our acquisition of Motorola.

The revenue growth rate of our Motorola business will also depend on a number of factors, including our reliance on several large customers, the absence of long-term exclusivity arrangements with such customers, our ability to gain significant market share in the mobile devices space, our reliance on third-party distributors, representatives and retailers to sell certain of its products and the successful implementation of our product and operating system strategies. Furthermore, industry consolidation in the telecommunications and cable industries could negatively impact Motorola’s business because there would be fewer network operators and it could be more difficult to replace any lost customers. Any of these factors could have a negative impact on Motorola’s business and have an adverse effect on our consolidated financial results.

We believe our operating margin will experience downward pressure as a result of increasing competition and increased expenditures for many aspects of our business, including Motorola. For instance, our operating margin will experience downward pressure if a greater percentage of our revenues comes from ads placed on our Google Network Members’ websites compared to revenues generated through ads placed on our own websites or if we spend a proportionately larger amount to promote the distribution of certain products, including Google Chrome. Both the margin on revenues we generate from our Google Network Members and the margin on revenues from our Motorola business is significantly less than the margin on revenues we generate from advertising on our websites. Also, the margins on advertising revenues from mobile devices and newer advertising formats are generally less than the margin on revenues we generate from advertising on our websites. Additionally, the margin we earn on revenues generated from our Google Network Members could decrease in the future if we pay an even larger percentage of advertising fees to our Google Network Members.

We are subject to increased regulatory scrutiny that may negatively impact our business.

The growth of our company and our expansion into a variety of new fields implicate a variety of new regulatory issues, and we have experienced increased regulatory scrutiny as we have grown. In particular, we are cooperating with the regulatory authorities in the United States and abroad, including the U.S. Federal Trade Commission (FTC), the European Commission (EC), and several state attorneys general in investigations they are conducting with respect to our business and its impact on competition. Legislators and regulators, including those conducting investigations in the U.S. and Europe, may make legal and regulatory changes, or interpret and apply existing laws, in ways that make our products and services less useful to our users, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. These changes or increased costs could negatively impact our business and results of operations in material ways.

We are regularly subject to claims, suits, government investigations, and other proceedings that may result in adverse outcomes.

We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust (such as the pending investigations by the FTC and the EC), intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Our acquisition of Motorola also exposes us to the risk of product liability and other litigation involving assertions about product defects, as well as health and safety, hazardous materials usage, and other environmental concerns. In addition, our Motorola business faces intellectual property litigation, as further discussed later, that exposes us to the risk of exclusion and cease and desist orders, which could limit our ability to sell Motorola products.

 

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Such claims, suits, government investigations, and proceedings are inherently uncertain and their results cannot be predicted with certainty. Regardless of the outcome, such legal proceedings can have an adverse impact on us because of legal costs, diversion of management resources, and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. It is possible that a resolution of one or more such proceedings could result in substantial fines and penalties that could adversely affect our business, consolidated financial position, results of operations, or cash flows in a particular period. These proceedings could also result in reputational harm, criminal sanctions, consent decrees, or orders preventing us from offering certain features, functionalities, products, or services, requiring a change in our business practices or product recalls or other field action, or requiring development of non-infringing or otherwise altered products or technologies. Any of these consequences could adversely affect our business and results of operations.

Our business depends on a strong brand, and failing to maintain and enhance our brand would hurt our ability to expand our base of users, advertisers, Google Network Members, and other partners.

The brand identity that we have developed has significantly contributed to the success of our business. Maintaining and enhancing the “Google” brand is critical to expanding our base of users, advertisers, Google Network Members, and other partners. We believe that the importance of brand recognition will increase due to the relatively low barriers to entry in the internet market. Our brand may be negatively impacted by a number of factors, including data protection and security issues, service outages, and product malfunctions. If we fail to maintain and enhance the “Google” brand, or if we incur excessive expenses in this effort, our business, operating results, and financial condition will be materially and adversely affected. Maintaining and enhancing our brand will depend largely on our ability to be a technology leader and continue to provide high-quality innovative products and services, which we may not do successfully.

A variety of new and existing U.S. and foreign laws could subject us to claims or otherwise harm our business.

We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations of existing laws and regulations) may also impact our business. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Any failure on our part to comply with these laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties.

Furthermore, many of these laws were adopted prior to the advent of the internet and related technologies and, as a result, do not contemplate or address the unique issues of the internet and related technologies. The laws that do reference the internet are being interpreted by the courts, but their applicability and scope remain uncertain. For example, the laws relating to the liability of providers of online services are currently unsettled both within the U.S. and abroad. Claims have also been, or may be, threatened and filed against us under both U.S. and foreign laws for defamation, invasion of privacy and other tort claims, unlawful activity, patent, copyright and trademark infringement, or other theories based on the nature and content of the materials searched and the ads posted by our users, our products and services, or content generated by our users. Moreover, recent amendments to U.S. patent laws will become effective in 2012 and may affect our ability to protect our innovations and defend against claims of patent infringement.

In addition, the Digital Millennium Copyright Act has provisions that limit, but do not necessarily eliminate, our liability for caching or hosting, or for listing or linking to, third-party websites that include materials that infringe copyrights or other rights, so long as we comply with the statutory requirements of this act. Any future legislation impacting these safe harbors may adversely impact us. Various U.S. and international laws restrict the distribution of materials considered harmful to children and impose additional restrictions on the ability of online services to collect information from minors. In the area of data protection, many states have passed laws requiring notification to users when there is a security breach for personal data, such as California’s Information Practices Act. We face similar risks and costs as our products and services are offered in international markets and may be subject to additional regulations.

 

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We are, and may in the future be, subject to intellectual property or other claims, which are costly to defend, could result in significant damage awards, and could limit our ability to use certain technologies in the future.

Internet, technology, and media companies own large numbers of patents, copyrights, trademarks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent holding companies may continue to seek to monetize patents they have purchased or otherwise obtained. As we have grown, the intellectual property rights claims against us have increased and may continue to increase as we develop new products, services, and technologies.

We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies, including Android, Google Search, Google AdWords, Google AdSense, Motorola, Google Books, Google News, Google Image Search, Google Chrome, Google Talk, Google Voice, and YouTube, infringe the intellectual property rights of others. Third parties have also sought broad injunctive relief against Motorola by filing claims in the U.S. International Trade Commission (ITC) for exclusion and cease and desist orders, which could limit our ability to sell Motorola products in the U.S. or elsewhere if our products or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business.

In addition, many of our agreements with our customers and partners, including certain suppliers, require us to indemnify them for certain intellectual property infringement claims against them, which could increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Moreover, supplier provided intellectual property indemnities to us, when obtainable, may not cover all damages and losses suffered by us and our customers from malfunctioning products.

Regardless of the merits of the claims, intellectual property claims are often time consuming, expensive to litigate or settle, and cause significant diversion of management attention. To the extent such intellectual property infringement claims are successful, they may have an adverse effect on our business, consolidated financial position, results of operations, or cash flows.

Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brand.

Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services and technologies. For example, effective intellectual property protection may not