Is Facebook to Blame for Google Inc.'s Ad Problems?

Though not as bad as some have maintained, the online search giant's drop in cost-per-click rates could be because of Facebook.

Apr 22, 2014 at 2:00PM

Investors and analysts have made it clear they were expecting a bit more from Google (NASDAQ:GOOG) (NASDAQ:GOOGL) in its recently announced 2014 Q1. Did Google's results warrant what's become a 5% drop in share price since its "disappointing" announcement on April 16? Probably not, but let's face it: Google CEO Larry Page and team have set the bar extremely high, meaning anything less than spectacular financial results will underwhelm. That's the price of success.

The aftermath of Google's earnings announcement, in addition to its drop in stock price, has been several analyst downgrades. It should be noted that the latest analyst downgrade set Google's target price at $700 a share, down from $750, but well above its current $535 a share range. Why the angst? Most industry pundits cite Google's dropping average cost per click -- in other words, how much its advertisers are willing to spend for ads -- as the culprit. But there may be an even bigger problem going forward for Google and its cost-per-click ads: Facebook (NASDAQ:FB).

The specs
Much of Google's Q1 went swimmingly, driven by a 19% jump in revenue compared to Q1 2013, to $15.4 billion. The impressive increase in revenue made its way down to Google's bottom line as well, including $4.3 billion in non-GAAP net income, a 6% year-over-year improvement.

Revenues for each of Google's primary divisions increased, led by a 21% pop in site revenues compared to Q1 2013, which accounted for nearly $10.5 billion of its $15.4 billion in total sales. "Other" revenues were up 48%, but were a mere $1.55 billion so they didn't play too large a part of Google's overall results.

Despite the drop in what advertisers are paying for each click of a Google ad, the number of paid clicks were up significantly year over year, rising 26% from Q1 2013. And, of course, Google is still a cash machine, generating $4.39 billion in net cash in the recently completed Q1, upping its cash and equivalents to $59.38 billion. So, what's not to like? A couple of things, and one could be the beginning of a disturbing trend, thanks to Facebook, not just a one quarter hiccup.

Areas of concern
One tidbit from Google's recent earnings announcement that should give investors pause is the increase in operating expenses, on both a dollar basis as well as a percentage of total revenues. At $5.34 billion in Q1 2014, Google saw its expenses increase more than $1.25 billion compared to last year.

And at 35% of revenues, operating expenses are taking up a larger piece of Google's revenue pie. In 2013's Q1, operating expenses accounted for just 31% of Google's revenues. Of course, despite the jump in expenses, Google was still able to show improvement in non-GAAP net income, but it's something that when combined with the cost-per-click drop could become a larger issue in the future.

Is Facebook to blame?
Mobile is part of Google's ad problem. As consumers continue migrating to devices on the go, advertisers are simply not willing to pay as much for each click as they are on PCs. According to one analyst, ad rates on mobile devices can cost as little as half those on desktop computers.

Google said it's not worried about lower mobile ad costs, however, because as consumers get used to buying products and services from their mobile devices, things will begin to even out. Maybe. But there's a potentially bigger concern: the manner in which marketing gurus are building their digital advertising campaigns. And that's where Facebook enters the picture.

As one industry pundit described it, Facebook will continue to earn more of a marketer's wallet because online advertising isn't just about direct response anymore -- in other words, Google's click ads. Today, marketing departments are looking to Facebook to build their brand, manage customers, and conduct public relations campaigns. The shift in digital advertising's purpose suits Facebook to a "T." Google search? Not so much.

Final Foolish thoughts
You could argue Google's recent sell-off has been overdone. Even as analysts bemoan Google's click rates, combined they still have an average share price target over $662 a share -- a nice jump from current levels. Long term, the change in how marketing department's view digital advertising will put pressure on Google's negative cost-per-click trend. Until Page and team find a way to adapt to a changing advertising industry, Facebook will continue to garner larger portions of marketing budgets, mobile and otherwise.

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Tim Brugger has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google-Class C Shares, and Google (A shares). The Motley Fool owns shares of Facebook, Google-Class C Shares, and Google (A shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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