Here come the droids

Search advertising growth supported a solid second quarter result for Google. As online advertising becomes more and more mainstream, traditional brand advertisers are embracing search as a legitimate part of their budget. Google’s new businesses are comparatively small, but no less important for its future growth. Penetration of Google’s Android mobile phone operating system is increasing, creating an important platform for future mobile search revenue.

“Recent issues have distracted the market from Google’s relentless progress”

The daily chart shows the share price is still in a downward channel and is currently struggling with the 50 day moving average. Ideally we would like to see a strong move higher that breaks clean through the 50 day MA and the downtrend resistance. The RSI has crossed above the 50 mid-point and is pointing higher. We expect to see a move toward the downtrend resistance - a break of which would open up the $600 price target.

Advertising revenue from Google websites and networks increased around 23% in the second quarter. Google’s total gross revenue lifted 23.5% to $6,820 million on the previous corresponding period. The cost of acquiring that traffic rose 19.2% to $1,732 million leading to a gross profit of $4,353 million for the quarter. After deducting other costs such as research and development, sales and marketing and general and administrative costs, Google’s operating profit of $2,365 million was 26.2% better than the same period last year. Net income of $1,840 million generated earnings per share of $5.71, an increase of 22.5%.

Google-owned sites generated about two-thirds of total revenue, while the network sites represent most of the balance. Google’s revenue is split approximately 48% domestic, 11% from the UK and about 41% from other international markets. Currency effects lowered Google’s reported revenue by $176 million in the quarter compared to the first quarter of 2010. Google conducts a comprehensive exchange risk management program which aims to mitigate these effects.

Aggregate paid clicks increased by about 15% in the quarter. This includes the websites of Google’s AdSense partners as well as its own websites. This easily offset the 4% increase in the average cost-per-click. Most of the traffic acquisition costs relate to the websites of the AdSense partners.

Wind power

Google owns and operates several massive data centres. The cost of running these centres is included in the $735 million quarterly cost classified as other costs. Google announced separately from its profit release that it has agreed to a 20-year deal to buy wind power from NextEra Energy to supply power to the data centres.

This deal is in addition to a $38.8 million investment in two wind farms in North Dakota, also developed by NextEra Energy. The total wind power now available to Google does not completely cover its total needs to run the data centres, but is indicative of the company’s corporate citizenship.

Google did not place a value on the deal with NextEra Energy which is the largest wind farm owner in the US with more than 7,500 megawatts of installed capacity.

China

Much has been written about Google’s spat with the Chinese government over the censorship of Google’s Chinese website. Google has now relented and complied with the Chinese government’s regulations but continues to provide a link to its uncensored Hong Kong website.

We do not see the issue as material to Google in the short term. The total size of the Chinese internet search advertising market was just $390 million in the second quarter, according to research company iResearch. Local company Baidu has a 70.8% share of that market compared to Google’s 27.3% (down from 29.5% in the first quarter).

Google’s difference of opinion with the Chinese government is more philosophical than economic at this stage, but it does not take a mathematician to ponder the financial potential of the market in the future. The company’s backdown, therefore, is at least practical.

Cash flow

The company’s cash flow generation remains impressive. Net operating cash in the second quarter totalled $2.09 billion compared to $1.61 billion in 2Q09. From this amount, Google funded $476 million of capital expenditure, most of which went into IT infrastructure investments - data centres, servers and networking equipment. Free cash flow was therefore $1.61 billion for the quarter.

Google’s capex has been subdued for the last year or so. The company is ramping up this element as it ventures into new areas of development, such as mobile operating systems.

At the end of the second quarter, Google reported net cash on its debt free balance sheet of $30,059 million. The company has shareholders’ funds of $40,613 million.

Here come the droids

Google is conducting its own search. The development of the mobile-related products and platforms is a precursor to a belated but important diversification of its core business.

The Android operating system is building strong momentum with around 160,000 devices activating each day. The relatively small number of applications is also improving with around 70,000 now available – still well short of Apple. Search on Android is therefore producing some stratospheric growth numbers as mobile traffic begins to proliferate among the population of devices.

Even though Google has now withdrawn its Nexus One mobile phone from production, the base of manufacturers using the Android OS is sufficiently large that it should not make a difference. Motorola’s new Droid X phone, for example, reportedly debuted to long customer queues and product sell-outs.

Apple’s widely publicised ‘antennagate’ stumble on its iPhone 4will only serve to heighten the competition in the smartphone market.

Looking at the weekly chart of Google we can see that since our initial purchase the share price found support at the confluence of the uptrend and the horizontal support around the $430/450 level. The price action is currently wrestling with resistance that is being provided by the 200 week moving average. A break above this level would give us an upside target of $600. Of some concern is the negative MACD trend signal although the shorter average looks to be turning higher which would be positive and could result in the generation of a buy signal.

Summary

Recent issues have distracted the market from Google’s relentless progress. That has created the opportunity we were looking for to invest in the company (see FAT223). Even at the current price, the market is pricing Google on a PE under 20 times. With the PE of the wider S&P500 market around 16 times, the premium for Google’s shares is small and also some way beneath its internet peers.

We continue to recommend Google as a buy to Members without exposure.