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Market Update

Google's 3Q Report Brings New Issues to Light

The firm's results brought hand-wringing from the market, and a changing business mix may pressure Google's long-run operating margins, says Morningstar's Rick Summer.

 Google's (GOOG) third-quarter earnings report brought hand-wringing from the market and new issues to light for us. While we believe our long-term thesis is intact, we are concerned that we may have been overly optimistic about operating leverage, given the changing revenue mix. Still, although we may modestly decrease our fair value estimate after completing our analysis, we consider the company slightly undervalued at these levels. Perhaps most importantly, we see no evidence of diminishing competitive advantages.

Revenues for Google Sites grew 15% compared with 2011, while revenue from the Google Network (ads placed on partner sites) grew 21% versus 2011. The strong dollar created a headwind to results as well, with a negative impact on Google's stand-alone revenue growth rate (excluding Motorola) of 600 basis points versus 2011. As Google Network revenue outpaced Google Sites, we believe this may be the start of an important trend: Google will increasingly rely on placing ads and distributing content for content owners to subscribers, but fee sharing and content acquisition costs will constrain the company's ability to gain operating leverage from the business.

With respect to operating costs, we note that other costs of revenue increased 57% sequentially (while Google's stand-alone revenue grew 5%). Even after accounting for effects of acquisitions and costs from the launch of the Nexus 7 tablet (Google's Android tablet), we estimate that other costs of revenue increased more than 30% versus the prior quarter. We believe this dramatic increase highlights Google's evolution toward a content distribution platform. Although the firm recognizes gross revenue by selling content on YouTube and Google Play, we suspect the bulk of the economics flow to the content owners, resulting in lower gross margins. If these efforts become even more significant relative to the total company, overall operating margins will suffer. Although we believe the company has other levers within is expense base to eventually expand margins, we may take a more cautious stance.

Furthermore, we believe the third quarter has offered a glimpse into Google's future--as nonsearch businesses increase their revenue contribution to Google's consolidated results, the margin profile for Google may be pressured. Overall, we have highlighted our belief that, due to Google's high investment rate in product development and evangelical sales efforts, the company is not maximizing near-term profitability. While we have previously believed that these investments will bear fruit and the company should benefit from significant operating leverage, we are becoming less confident in that view. We are concerned that our existing forecast may be optimistic.

Lastly, we are still mostly untroubled by trends in Google's cost-per-click ad pricing. In the quarter, management highlighted continued declines in CPCs, but countered that overall increases in paid clicks are just as important. In short, we agree. Short-term declines in ad pricing do not indicate any competitive weakness, nor do they indicate that industry players will be unable to monetize mobile advertising more effectively. In our view, mobile ads will never be more ineffective as they are today, and monetization will only improve.

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