Google Maintaining Its Near-Term Edge

By Ryan C. Fuhrmann | July 19, 2011 AAA

Internet search and advertising giant Google (Nasdaq:GOOG) saw its share price jump forward after reporting impressive sales growth during its second quarter. Profits increased by a smaller margin, as Google is spending heavily to stay ahead of rivals. Its long-term ability to maintain dominance in online advertising and extend this to other venues is highly uncertain, but the stock is cheap if current growth trends persist over the next few years.

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Second Quarter Recap
Revenue advanced 32.3% to $9 billion. Google website revenue made up the bulk of total revenue at 69%, and improved 39%. The next-largest revenue source stems from member websites, or third parties that use Google's AdSense program, in which Google shares ad revenue with these parties. Revenue rose 20% to make up 28% of the total top line in this area. The revenue that Google shares with these third parties is called "traffic acquisition costs", and reached $2.1 billion during the quarter. Other revenue grew 20.2% and accounted for less than 4% of revenue, as it consists of Google's mobile phone business that has yet to generate any significant advertising revenue for the firm.

Total costs increased as well, rising 37.9% to $6.1 billion as Google is spending heavily to maintain its advertising lead on archrivals, including Yahoo! (Nasdaq:YHOO) and Facebook, and smaller rivals such as AOL (NYSE:AOL) and IAC/InterActiveCorp (Nasdaq:IACI). For instance, it recently launched Google+ to compete with Facebook, and boasted that 10 million users had signed up since it was launched. As a result of this spending, operating income rose 22% to $3.1 billion, though this still represented a very healthy operating margin of almost 32% of sales. Net income also rose 36% to $2.5 billion.

Outlook
For the full year, analysts project sales growth of 26% and total sales of $27.7 billion. The current consensus earnings projection is $33.82, or year-over-year growth of approximately 28%.

The Bottom Line
Google's basic strategy is to develop website content for little to no cost to consumers, and make money from advertising. The company is also working to develop dominance on mobile phone applications, television sets that include working with Sony (NYSE:SNE) to integrate software and hardware, and replicate the success it has experienced on the internet. Google's estimated market share of the online search services is approximately 65%.

At a forward P/E of about 17.7, a fair amount of growth is already discounted in the share price valuation. There is also little assurance that Google will continue to dominate online search and advertising. Just a few years ago, AOL and Yahoo! held sizable leads on the competition, but were quickly outgunned by Google. With 20-30% sales and profit growth over the next five years, the stock is cheap, but these are pretty ambitious growth targets, given that the technology sector evolves extremely rapidly, and frequently turns today's winners into has-beens. (Find out how the PPI can be used to gauge the overall health of the economy. Check out Predict Inflation With The Producer Price Index.)

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