Google (NASDAQ:GOOG) posted its second quarter results on July 17. The company reported 22% year-on-year growth in revenues to $15.95 billion, which were in line with our expectations. Its operating income from continuing operations grew by approximately 22% to $4.26 billion. However, the company continued to invest heavily, with some pressure on margins. The company also reported lower traffic acquisition costs in absolute numbers and as a percentage of advertising revenues: 23% in Q2 2014 versus 25% in 2013.  Pricing pressure on online ads drove a 6% year-over-year decline in cost-per-click (CPC). However, aggregate paid clicks, which represent the number of ads served across Google properties, posted a solid 25% year-over-year growth. This led to a 23% increase in advertising revenues during the quarter.
Multi-platform Strategy Delivers Growth in Ad Volume
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In our pre-earnings note, we stated that the multi-platform enhanced campaigns program will help the company to post growth in its ad revenues. Additionally, in our note published earlier, we had argued that mobile is the key to Google’s revenue growth over the long term. Considering that advertisers are increasingly advertising on mobile devices, bundling of ad campaigns proved to be a good move. This new program, which automatically bundles desktop, tablet and cellphone ads for all campaigns, was instrumental in increasing the aggregate paid clicks, which mirrors the number of ads sold by 25% during the quarter. We expect this trend to continue as more advertisers switch to enhanced campaigns in the future. Additionally, we think that the Android platform, which now runs on over a billion devices, will continue to lead as the preferred mobile device platform, and this will increase the number of aggregate paid clicks, which can offset the decline in CPC to some extent going forward.
Cost-Per-Click Falls as Ads on Mobile Increases
We currently estimate that PC search ads and mobile search ads contribute approximately 65% to the firm’s value. Online ad spending is expected to increase in general. eMarketer has predicted that worldwide mobile ad spending will exceed $31.45 billion in 2014.  Even though mobile search ads are expected to only generate 17% of the company’s total revenues in 2014, we expect the proportion to increase to over 35% by 2020.
The cost-per-click, a metric that measures the price paid for the number of times a visitor clicks on a search ad, has been on a steady decline for the past few years. The recent trend is indicative of geographic mix, device mix, property mix, as well as the ongoing product and policy changes. While international revenue contributes nearly 58% of the total revenues, mobile devices account for a huge influx of queries for Google.  Advertisers have realigned their ad budgets in favor of mobile devices. Traditionally, CPC for mobile ads is lower compared to that of a PC. As a result, the average blended CPC (CPC for both mobile and PC) declined by 6% year-over-year during the quarter. However, CPC was flat sequentially, since the company has successfully launched the advanced campaign that bundles mobile ads with desktop ads, and eliminates the difference between PC CPC and mobile CPC. Going forward, we expect that the growth in mobile advertising will continue to weigh on CPC.
Youtube Boosts Ad Volumes
In our pre-earnings note, we mentioned that we would be closely watching YouTube because it caters to the rapidly growing online video ad space. During the earnings call we got some encouraging metrics from the management, which makes us confident about YouTube as an essential driver of revenue growth going forward. The management stated that paid clicks in YouTube engagement ads like TrueView, and other owned and operated properties like Maps and Finance, increased approximately 33% over the second quarter of 2013 and increased approximately 6% over the first quarter of 2014. The primary reason for Google’s dominance in the video ads industry is its reach among users with nearly 150 million unique viewers as of May 2014.  We think that YouTube is important because, according to our estimates, this division constitutes just under 10% of Google’s value. Revenues from this division were around $3.7 billion in 2013, and we think that they will continue to grow and reach around $18 billion by the end of our forecast period.
Capitalizing on the Popularity of Android With Play Store
Google’s phone division makes up 8% of its value. Google continues to leverage the growing popularity of its Android operating system with app sales on its Play store. Furthermore, Google’s apps (such as Google Play, Search and the YouTube app) have over 50% reach for the mobile audience according to comScore.  This was reflected in the growth of Google’s other revenues, which grew by 53% year-over-year to $1.6 billion, and is primarily composed of revenues from sale of digital content. Going ahead, we expect revenues from digital content to grow to $5.6 billion by 2020, bolstered by the increasing use of Internet to deliver content such as movies, books and music.
Capital Expenditure Continues to Soar
Google continues to invest heavily in Internet infrastructure and reported $2.65 billion in capital expenditures in the second quarter of 2014. Majority of capital investments are for IT infrastructure, including data center construction, servers and networking equipment. Google has been steadily ramping up its spending for the past couple of years, in an effort to improve its return on investment and quality of service. We expect capex spending to continue at these levels in the coming quarters, which will lower free cash flow.
We are in the process of updating our model. We currently have a $544 price estimate for Google, which is in line with the current market price.
- 8-K, SEC [↩]
- Driven by Facebook and Google, Mobile Ad Market Soars 105% in 2013, March 19 2014, www.emarketer.com [↩]
- Earnings Transcript Q2 [↩]
- comScore Releases May 2014 U.S. Online Video Rankings, June 16 2014, www.comscore.com [↩]
- comScore Reports May 2014 U.S. Smartphone Subscriber Market Share, July 3 2014, www.comscore.com [↩]