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Google disappoints despite strong profit growth

Google Inc. co-founders Sergey Brin and Larry Page have always told Wall Street that positioning the Internet search leader to realize its long-term ambitions is more important to them than meeting the earnings expectations of shortsighted investors. Just in case anyone forgot, the company punctuated the point with its second-quarter results.
Sergey Brin
Sergey Brin, co-founder and president of GoogleDouglas C. Pizac / AP
/ Source: The Associated Press

Google co-founders Sergey Brin and Larry Page have always told Wall Street that positioning the Internet search leader to realize long-term ambitions is more important than hitting the short-term financial targets of investors.

Just in case anyone forgot, the company punctuated the point with its second-quarter results.

Propelled by the online advertising boom, Google Inc. reported late Thursday that revenue surged to $3.87 billion, up 58 percent from the same time last year — a gain that was slightly above analyst estimates.

But Google’s profit margins narrowed as management ramped up spending to hire additional employees, develop new products, open more data centers and buy more content for its Web sites. A change in how the Mountain View-based company accounts for employee bonuses also weighed on the results.

Add it all up, and Google was left with a 28 percent increase in its second-quarter earnings, by far its slowest growth since becoming a public company in August 2004.

Investors expressed their dismay by sending Google shares down fell $30.36, or 5.5 percent, to $518.23 in afternoon trading Friday. The harsh reaction erased wiped out about $10 billion in shareholder wealth.

“It seems like a pretty significant overreaction in the market,” said Cantor Fitzgerald analyst Derek Brown. “The quarter wasn’t perfect, but it was really good.”

Although disappointed with Google’s margins, American Technology Research analyst Rob Sanderson viewed Friday’s sell-off as a buying opportunity. He raised his 12-month target for Google’s stock to $685, up from $600 previously.

Other analysts remained concerned about Google’s budget management.

Oppenheimer and Co. analyst Sandeep Aggarwal suspects the second quarter may have heralded a fundamental change in how Google is handling its costs, signaling margins could continue to be squeezed. As evidence, he pointed out that Google’s annualized operating profit fell to $320,503 per employee in the second quarter, a 22 percent drop from $410,663 at the same time last year. Aggarwal, however, maintained a “buy” rating on Google’s stock.

Standard and Poor’s equity analyst Scott Kessler wondered whether Google’s increased spending stems from tougher competition. He also thinks management’s dismissive attitude toward Wall Street could haunt the company, despite its success so far.

“Even though (the company) has asserted it manages for the long-term, we think a seemingly less significant focus on quarterly performance can hurt results, stock performance and investor sentiment,” Kessler wrote in a Friday note.

The backlash didn’t seem to faze Brin, whose estimated $16 billion fortune hinges on Google’s stock price.

“I guess there are some people out there who think we have already picked all the low-hanging, juicy fruit, but I think the jury is still out on how far we can take this business,” Brin said in an interview.

Capitalizing on the Internet’s largest ad network, Google earned $925.1 million, or $2.93 per share, during the three months ended in June. That compared with net income of $721.1 million, or $2.33 per share, at the same time last year.

If not for costs associated with employee stock compensation, Google said it would have earned $3.56 per share. That figure missed the average analyst estimate of $3.59 per share among analysts polled by Thomson Financial. It marked just the second time that Google did not exceed analyst expectations in its 12 quarters as a public company.

The company’s success revolves around its search engine, which processes nearly half of all search requests in the United States. The search engine serves as the hub of a lucrative ad network that spans thousands of Web sites.

Already well-known for pampering its employees, Google poured even more money into expanding its work force during the spring. Google hired 1,548 additional employees in the last quarter, compared with the 1,152 workers it added during the same period last year. Google ended June with 13,786 employees, a 74 percent increase during the past year.

The company believes the extra talent will eventually pay off as employees develop new products or sell more ads.

Still, Google Chairman Eric Schmidt told analysts in a conference call that the company would be more careful about adding employees in future quarters. Brin reiterated that sentiment in an interview, saying the company would be more disciplined in its future hiring now that it has attracted enough employees to pursue its ambitions.

The company also spent substantially more on research and development, sales and marketing and “content acquisition costs,” which were included in its quarterly breakdown for the first time.

RBC Capital Markets Jordan Rohan believes the downturn in Google’s stock wouldn’t have been as severe if management had been proactive in letting investors know some of the accounting and spending factors that diminished profits. But that wouldn’t be a Google-like thing to do, Rohan wrote in a Friday note to clients.

The second quarter “served as a reminder that Google remains an unconventional company with chronic investor communications miscues and unorthodox decision processes,” Rohan wrote.