Google is human, earnings miss

NEW YORK (CNNMoney.com) -- Internet search leader Google reported a strong increase in revenue and earnings for the second quarter Thursday thanks to explosive demand for online advertising. But profits fell slightly short of expectations, disappointing investors that have grown accustomed to Google easily surpassing consensus estimates.

Shares of Google plunged more than 7 percent after hours following a slight drop in regular trading on the Nasdaq.

Google (Charts, Fortune 500), based in Mountain View, Calif., posted sales of $3.87 billion, up 58 percent from a year ago. Excluding advertising revenue shared with partners, a figure known as traffic acquisition costs or TAC, sales came in at $2.72 billion, ahead of the $2.68 billion in sales analysts were expecting on this basis.

The company reported a net profit of $925 million, or $2.93 per share, an increase of 28 percent from last year. So-called pro forma earnings, which don't include stock-based compensation, tax benefits and other items, were $3.56 per share, missing analysts' forecasts of $3.59 per share.

Shares of Google have surged nearly 20 percent so far this year and are currently less than 2 percent below their all-time high.

Investors have been bullish on Google since it continues to enjoy a wide market share lead in search over Yahoo (Charts, Fortune 500), which reported sluggish sales growth and a decline in profits for the second quarter Tuesday, Microsoft's (Charts, Fortune 500) MSN and IAC (Charts, Fortune 500)-owned Ask.com.

Wall Street is also optimistic that Google's recent merger spree will pay dividends as the company seeks to expand in areas beyond keyword search. The company bought online video kingpin YouTube last year and is in the process of buying Internet ad placement firm DoubleClick and security software service Postini.

But the earnings miss, only the second since Google went public in August 2004, may be spooking some investors, who had believed that the company would once again blow away Wall Street forecasts.

One analyst said investors may be overreacting since Google is still, far and away, the dominant player in Internet advertising.

"These numbers are really strong. Whatever weakness you are seeing today in the stock is temporary. The fundamentals are phenomenal," said Steve Weinstein, an analyst with Pacific Crest Securities.

But Jordan Rohan, an analyst with RBC Capital Markets, said investors should not be surprised that Google's earnings missed estimates and that sales did not come in substantially higher than projections.

For one, the second quarter is typically not as strong for Internet advertising as the first quarter and fourth quarter since it corresponds with the end of spring and beginning of summer, a time when online traffic tends to dip in the United States.

During a conference call with analysts, Google chairman and CEO Eric Schmidt said that seasonality was not a problem during the quarter though, with traffic at Google's site being higher than the company had expected.

He also said Google did not see an impact from a temporary boycott of ads from eBay (Charts, Fortune 500) in the quarter. The online auction giant, Google's biggest customer, allegedly pulled some business from Google to protest a party Google was planning to hold to promote its Google Checkout product, which competes with eBay's PayPal.

Still, sales weren't the reason investors were upset. Google has been spending aggressively in order to boost future growth prospects. This may be a wise move strategically but it does hurt short-term profits, helping to explain why earnings were only up 28 percent despite a nearly 60 percent increase in revenue.

Schmidt said that the company did expect to see meaningful growth in the future from newer businesses that it has invested in such as video advertising on YouTube as well as so-called display advertising, which includes various forms of graphical ads. But he declined to give any specifics about what percentage of revenue was currently coming from businesses beyond search.

Research and development expenses increased nearly 90 percent in the quarter while sales and marketing costs surged more than 80 percent. Schmidt said bonuses to employees also contributed to increased costs in the quarter.

"Google did exactly what they told us they would, they spent as much as they possibly could to fund future growth. This earnings miss wasn't that hard to figure out," Rohan said, adding that Google might want to rein in some of its spending.

Schmidt conceded during the call that Google will keep a closer eye on its rapidly expanding headcount in the future. Google finished the quarter with 13,786 employees worldwide, up from 12,238 employees at the end of the first quarter in March.

Another analyst suggested that profit estimates may have been too high for Google, which does not give sales or earnings guidance and is pretty tight-lipped about other financial measures, since analysts were caught off guard by the increase in bonus payments. Absent this increase however, Google did not appear to be spending out of control.

"The quarter was so much better on the top line than we expected thanks to the strength of international expansion but expenses were much higher than we thought they should be because of the bonuses," said Marianne Wolk, an analyst with Susquehanna Financial Group.

"There wasn't one unusual item that made a big difference. Google could have handily beat forecasts if not for the adjustments in bonus accruals. When investors examine that, they'll feel comfort and it won't appear as if investments are running amok," she added.

And chief financial officer George Reyes said Google will continue to invest heavily in the future, particularly in more rapidly growing international markets. Google's international sales surged 78 percent in the quarter from a year ago and accounted for 48 percent of Google's total revenue.

Schmidt said Google has invested heavily in China in particular in order to compete against top Chinese Internet companies like Baidu (Charts) and Sina (Charts).

But Reyes added that Google will be more discerning with its cash in the future.

"We are taking a careful look at investments and how we allocate resources around the world," Reyes said during the call. Google finished the quarter with more than $12.5 billion in cash and marketable securities on its balance sheet.

Analysts quoted in this story do not own shares of Google and their firms have no investment banking ties to the company.