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What's Driving Google's Growth

Jeremy Glaser

Jeremy Glaser: For Morningstar.com I am Jeremy Glaser. Google beat analysts' expectations again in the first quarter. I am here with Morningstar equity analyst Larry Witt to talk a little bit about what drove this high performance.

Larry, thanks for joining me.

Larry Witt: Absolutely Jeremy. Thanks for having me.

Glaser: What was the most surprising aspect of this earnings release for you?

Witt: One thing that is important to point out is that Google's revenue not only continues to grow, but it has accelerated over the last three quarters. So revenue growth is getting stronger. We think there are a few things really benefiting Google right now.

First of all you have the secular shift of advertising online. Google continued to take market share within that category. But also as the advertising market is improving overall, thanks to a stronger economy, you have seen their revenue growth accelerate over the last few quarters. And I think that is a pretty good indication that other media businesses will fare better this quarter than they have over the last couple of years.

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Glaser: Is there any big divide between revenue from the United States and advertising revenue abroad?

Witt: They are actually both pretty strong right now. International growth had been stronger for quite a while even though the whole world was going through this financial crisis and this economic slowdown. They were still far behind in terms of actually penetrating these international markets. There was a much smaller percentage of revenue going to search. So there is still a secular growth that was masking some of the economic weakness.

So that had continued to grow pretty well throughout, whereas the U.S. market was pretty weak for a while. But that has come back pretty strong, and both segments are growing quite nicely now.

Glaser: Are they growing profitably or are they just growing?

Witt: No, absolutely they are growing profitably. Actually their operating margins have expanded throughout the economic downturn, and still now it is expanding. They have been much more disciplined than we anticipated in cutting costs. Shutting down some of their pet projects that really were never going to turn into real businesses. And they have done a pretty good job of that.

In addition they actually cut their capital expenditures quite a bit since the second half of 2008. So as that bleeds to the income statement in depreciation and amortization, their operating margins improved quite nicely.

Glaser: Google really is a giant advertising company. Sometimes we like to think of it as the next Microsoft, or they are competing with Apple, or they are crusading for human rights in China. It is really an advertising business.

But they do have a few of these side projects. The mobile phone business is one that we hear a lot about. They are now selling their own phone, and also have the Android operating system. Is that something that they are gaining traction in that you see as a bigger part of the business? Or is it still just going to be a hobby?

Witt: I think it is important for Google. I think when you look at the number of Android phones that are on the market it is clearly gaining market share. The problem is they don't really make money off of most of those phones.

They do sell their own phone called the Nexus One, but really that is just a souped up Android phone. I think overall their main goal is to maybe negate the power that an Apple has. So even if they are not making money on every phone that is shipped, the fact that these phones are being run on a Google operating system, they know that people are going to be using Google apps, Google search, and they are going to earn revenue that way.

For example, if Apple was the only game in town they could say, "Look Google, if you want to be on our platform you are going to have to pay us an exorbitant amount of revenue share." So they are really trying to negate Apple's power.

Glaser: Finally, what is your view of Google for the rest of the year, the upcoming years and also on the valuation of the stock right now?

Witt: We currently think it is fairly valued. Our fair value estimate is $550. It is currently trading around $560, $570, depending on what it is doing after hours. Overall we think it is a good company. But, as you mentioned, it is an advertising company. 95 percent of their revenue comes from advertising, so I wouldn't really compare it to other tech companies like an Apple or a Microsoft. But just realize that this company is going to grow as they are able to grow their advertising revenue. And that is pretty much what it is, and it is going to be for the foreseeable future.

Glaser: Larry, thanks for talking with me today.

Witt: Thank you.

Glaser: For Morningstar.com I'm Jeremy Glaser.