LIVE: Surprise! Google Beats Third-Quarter Profit Forecasts

Google just reported third-quarter results, and it managed to defy skeptics who thought it might finally fall victim to the poor economy. Net revenues of $4.04 billion were dead-on with analysts’ estimates, and profits before special items was $4.92 a share, handily beating expectations. The big reason: It reined in expenses, hiring fewer people and actually cutting capital expenses from a year ago.

Analysts had forecast $4.80 in earnings per share, minus special items such as stock option expenses, on net revenues of $4.05 billion after payments to partners that run Google ads on their sites. However, many analysts were informally assuming Google might come in slightly below their stated estimates and have been reducing estimates and price targets in recent weeks. A year ago, Google earned $3.92 a share.

In after-hours trading, Google’s stock, which closed up 4% today in a late rally along with the broader market, to $356.50 a share, was rising 10%, though that will likely vacillate after the earnings call. The stock had fallen 11% in the last three sessions for before today.

More from the release after the jump. And here’s CEO Eric Schmidt, which at the outset doesn’t indicate much about the future to my reading, except that he’s acknowledging the poor economy. However, he has done that before as well.

“We had a good third quarter with strong traffic and revenue growth across all of our major geographies thanks to the underlying strength of our core search and ads business. The measurability and ROI of search-based advertising remain key assets for Google. While we are realistic about the poor state of the global economy, we will continue to manage Google for the long term, driving improvements to search and ads, while also investing in future growth areas such as enterprise, mobile, and display.”

Google third-quarter results are less important as a sign of the times than what’s coming next. And partly because Google doesn’t provide earnings guidance, analysts are somewhat pessimistic. “There’s a lot of doubt about whether the 2009 estimates are too high,” says John Aiken, managing director of Majestic Research. Currently, the consensus is for 23% growth, but Aiken thinks 20% is more likely, and even 15% is possible.

Although Google has been largely shielded from the downturn so far, the now nearly certain prospect of a protracted recession seems likely to affect even search advertising, especially since it is driven significantly by small and medium-sized businesses. Perhaps to an even greater extent than their larger brethren, they face dropping consumer demand and a scarcity of capital thanks to the credit crunch.

And even if they keep spending on search ads, it’s possible consumers who click on them will end up deciding to buy less often, which would make them less effective for advertisers. A third-quarter study from SearchIgnite this week, for instance, did find one trouble spot: Retailers in particular are starting to reduce their search ad spending, down 10% in September.

So Google’s third-quarter results aren’t nearly as important as the prospects for the fourth quarter and 2009. We’ll hear more about this from the earnings call, which starts shortly. I’ll add what I hear after the jump.

Tidbits from the conference call:

Schmidt says traffic and revenue were "solid" and search query traffic rose in all vertical markets.

"The economic situation today is globally worse than what people were predicting just a month ago. ... But we're optimistic about Google's future."

New CFO Patrick Pichette noted that most geographies were strong, but mentioned the U.K. showed some weakness, up only 17% including currency adjustments. "Our core business continues to demonstrate strength despite a challenging economic environment."

Now cofounder and President of Technology Sergey Brin is talking about improvements in search, YouTube's various experiments in ads, and Android phones. Not much news you haven't heard yet.

He says more than 1 million businesses are using Google Apps.

Now on to analysts' questions. First, on the economy: Schmidt: "We see fluctuations, which are more complex than they may seem. Some things go up, some things do down." OK, Eric. He calls on Google economist Hal Varian: "It's very hard to tell what things are going to look like on a going-forward basis." OK, Hal. Now Jonathan Rosenberg mentions results may vary according to specifics on Google's quality adjustments on search ads. So, no real answer here.

Will economy prompt Google to cut costs, or delay investing in opportunities such as mobile. Schmidt: Google has shown courage when we need to ... as well as expense containment." Pichette talks about how Google will show discipline, but no specifics.

Question about whether Google is surprised at the reaction of advertisers to the Google deal. Sounds like they were, because Schmidt says, "Many of the complaints are based on the fact that many people don't understand how auctions work, or the benefits."

Question about whether advertisers are changing behavior because of the economy. Not really, says Varian: "Advertisers are willing to take all the clicks we can give them at the current CPCs (cost per click)," and he thinks that will continue regardless of the economy.

Question about impact of economy on retail given eBay's bearish outlook: Varian, as he did last quarter, still think Google could actually benefit as people are careful about shopping and search even more for better deals.

Question about improvement in margins--from cost cutting or change in advertising arrangements? Pichette: "Across all categories of expenses, people have been very diligent" in watching expenses. Hiring was less than in previous quarters. Capital expenditures were lowest since Q1 2006, another analyst notes.

Stock's still up about 9% in extended trading, so nothing on the call changed people's minds that this was an upside surprise.

Here's the earnings release:

Google reported revenues of $5.54 billion for the quarter ended September 30, 2008, an increase of 31% compared to the third quarter of 2007 and an increase of 3% compared to the second quarter of 2008.
Google reports its revenues, consistent with GAAP, on a gross basis without deducting traffic acquisition costs (TAC). In the third quarter of 2008, TAC totaled $1.50 billion, or 28% of advertising revenues.

Google reports operating income, net income, and earnings per share
(EPS) on a GAAP and non-GAAP basis. The non-GAAP measures, as well as free cash flow, an alternative non-GAAP measure of liquidity, are described below and are reconciled to the corresponding GAAP measures in the accompanying financial tables.

l GAAP operating income for the third quarter of 2008 was $1.74
billion, or 31% of revenues. This compares to GAAP operating income of $1.58 billion, or 29% of revenues, in the second quarter of 2008.
Non-GAAP operating income in the third quarter of 2008 was $2.02 billion, or 37% of revenues. This compares to non-GAAP operating income of $1.85 billion, or 34% of revenues, in the second quarter of 2008.

l GAAP net income for the third quarter of 2008 was $1.35 billion as
compared to $1.25 billion in the second quarter of 2008. Non-GAAP net income in the third quarter of 2008 was $1.56 billion, compared to
$1.47 billion in the second quarter of 2008.

l GAAP EPS for the third quarter of 2008 was $4.24 on 318 million
diluted shares outstanding, compared to $3.92 for the second quarter of 2008 on 318 million diluted shares outstanding. Non-GAAP EPS in the third quarter of 2008 was $4.92, compared to $4.63 in the second quarter of 2008.

l Non-GAAP operating income, non-GAAP operating margin, non-GAAP net
income, and non-GAAP EPS are computed net of stock-based compensation (SBC). In the third quarter of 2008, the charge related to SBC was $280 million as compared to $273 million in the second quarter of 2008. Tax benefits related to SBC have also been excluded from non- GAAP net income and non-GAAP EPS. The tax benefit related to SBC was
$63 million in the third quarter of 2008 and $48 million in the second quarter of 2008. Reconciliations of non-GAAP measures to GAAP operating income, operating margin, net income, and EPS are included at the end of this release.

Q3 Financial Highlights

Revenues – Google reported revenues of $5.54 billion for the quarter ended September 30, 2008, representing a 31% increase over third quarter 2007 revenues of $4.23 billion and a 3% increase over second quarter 2008 revenues of $5.37 billion. Google reports its revenues, consistent with GAAP, on a gross basis without deducting TAC.

Google Sites Revenues - Google-owned sites generated revenues of $3.67 billion, or 67% of total revenues, in the third quarter of 2008. This represents a 34% increase over third quarter 2007 revenues of $2.73 billion and a 4% increase over second quarter 2008 revenues of $3.53 billion.

Google Network Revenues - Google’s partner sites generated revenues, through AdSense programs, of $1.68 billion, or 30% of total revenues, in the third quarter of 2008. This represents a 15% increase over network revenues of $1.45 billion generated in the third quarter of
2007 and a 1% increase over second quarter 2008 revenues of $1.66 billion.

International Revenues - Revenues from outside of the United States totaled $2.85 billion, representing 51% of total revenues in the third quarter of 2008, compared to 48% in the third quarter of 2007 and 52% in the second quarter of 2008. Had foreign exchange rates remained constant from the second quarter of 2008 through the third quarter of 2008, our revenues in the third quarter of 2008 would have been $59 million higher. Had foreign exchange rates remained constant from the third quarter of 2007 through the third quarter of 2008, our revenues in the third quarter of 2008 would have been $168 million lower.

In the third quarter, we recognized a benefit of $34 million to revenue through our foreign exchange risk management program.

Revenues from the United Kingdom totaled $776 million, representing 14% of revenue in the third quarter of 2008, compared to 16% in the third quarter of 2007 and 14% in the second quarter of 2008.

Paid Clicks – Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 18% over the third quarter of 2007 and increased approximately 4% over the second quarter of 2008.

TAC - Traffic Acquisition Costs, the portion of revenues shared with Google’s partners, increased to $1.50 billion in the third quarter of 2008. This compares to TAC of $1.47 billion in the second quarter of 2008. TAC as a percentage of advertising revenues was 28% in the third quarter, compared to 28% in the second quarter of 2008.

The majority of TAC expense is related to amounts ultimately paid to our AdSense partners, which totaled $1.33 billion in the third quarter of 2008. TAC is also related to amounts ultimately paid to certain distribution partners and others who direct traffic to our website, which totaled $167 million in the third quarter of 2008.

Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, amortization of intangible assets, content acquisition costs as well as credit card processing charges, increased to $678 million, or 12% of revenues, in the third quarter of 2008, compared to $674 million, or 13% of revenues, in the second quarter of 2008.

Operating Expenses - Operating expenses, other than cost of revenues, were $1.63 billion in the third quarter of 2008, or 29% of revenues, compared to $1.64 billion in the second quarter of 2008, or 31% of revenues. The operating expenses in the third quarter of 2008 included $859 million in payroll-related and facilities expenses, compared to $810 million in the second quarter of 2008.

Stock-Based Compensation (SBC) – In the third quarter of 2008, the total charge related to SBC was $280 million as compared to $273 million in the second quarter of 2008.

We currently estimate stock-based compensation charges for grants to employees prior to October 1, 2008 to be approximately $1.1 billion for 2008. This does not include expenses to be recognized related to employee stock awards that are granted after October 1, 2008 or non- employee stock awards that have been or may be granted.

Operating Income - GAAP operating income in the third quarter of 2008 was $1.74 billion, or 31% of revenues. This compares to GAAP operating income of $1.58 billion, or 29% of revenues, in the second quarter of 2008. Non-GAAP operating income in the third quarter of
2008 was $2.02 billion, or 37% of revenues. This compares to non-GAAP operating income of $1.85 billion, or 34% of revenues, in the second quarter of 2008.

Interest Income and Other, Net – Interest income and other was $21 million in the third quarter of 2008, compared with $58 million in the second quarter of 2008. The decrease was primarily related to an increase in expenses substantially due to more activity under our foreign exchange risk management program. The cost of the options used to manage our foreign exchange risk is amortized on a mark-to-market basis. As a result, the amount of amortization expense we recognize in any particular quarter is impacted by how much the option moves into or out of the money, as well as the underlying currency's volatility.

Net Income – GAAP net income for the third quarter of 2008 was $1.35 billion as compared to $1.25 billion in the second quarter of 2008.
Non-GAAP net income was $1.56 billion in the third quarter of 2008, compared to $1.47 billion in the second quarter of 2008. GAAP EPS for the third quarter of 2008 was $4.24 on 318 million diluted shares outstanding, compared to $3.92 for the second quarter of 2008, on 318 million diluted shares outstanding. Non-GAAP EPS for the third quarter of 2008 was $4.92, compared to $4.63 in the second quarter of 2008.

Income Taxes – Our effective tax rate was 24% for the third quarter of 2008.

Cash Flow and Capital Expenditures – Net cash provided by operating activities for the third quarter of 2008 totaled $2.18 billion as compared to $1.77 billion for the second quarter of 2008. In the third quarter of 2008, capital expenditures were $452 million, the majority of which was related to IT infrastructure investments, including data centers, servers, and networking equipment. Free cash flow, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. In the third quarter of 2008, free cash flow was $1.73 billion.

We expect to continue to make significant capital expenditures.

A reconciliation of free cash flow to net cash provided by operating activities, the GAAP measure of liquidity, is included at the end of this release.

Cash – As of September 30, 2008, cash, cash equivalents, and marketable securities were $14.4 billion.

On a worldwide basis, Google employed 20,123 full-time employees as of September 30, 2008, up from 19,604 full-time employees as of June 30, 2008.