Does Google Have Work to Do In the Near Term?

Search engine specialist Google (NASDAQ: GOOGL  ) (NASDAQ: GOOG  ) gave mixed signals when it recently announced its second-quarter results. On one hand, growth in its core search business combined with increased advertising volumes to lead to an estimate-beating 22% year-over-year rise in revenue. On the other hand, Google's rising expenditure and fall in ad prices took their toll on the company's adjusted earnings of $6.08 per share, which fell short of Street expectations of $6.24 per share.

Although investors responded positively to the revenue growth as shares went up by 1.4% in extended trading, the small percentage increase indicated persistent concerns about the company's earnings in recent quarters.

The problem with ad prices
Google is increasingly feeling the heat as a growing section of consumers access its services on mobile devices such as smartphones and tablets, shunning desktop systems where advertising rates tend to be higher. With the company unable to charge the same higher rates for mobile ads as for the original desktop ad business, Google's cost per click, or the amount paid by an advertiser every time a person clicks on an ad, fell by 6% on a year-over-year basis during the quarter.

However, that disadvantage was partly offset by its strategy of boosting the core ad business through a host of additional features on YouTube and other company-owned sites. That brought in more user traffic, leading to a 33% hike in the total volume of ad clicks. With Google charging advertisers each time a person clicks on a promotional link, the increased volume of such clicks led to higher revenue during the quarter.

What about the others?
At the same time, although the company has been struggling with declining mobile ad rates for the last two years, competition actually seems to be doing quite well in this area. Data from research firm eMarketer shows that social media giant Facebook (NASDAQ: FB  ) was able to gain 16% share of the global mobile ad market in 2013, a marked increase from a 9% share in the previous year. In fact, mobile advertising made up for a whopping 59% of Facebook's overall ad revenue during its last reported fourth quarter.

Things that also matter
Apart from the decline in ad prices, Google's rising expenditure was also responsible for lower-than-estimated earnings during the quarter. These included a 25% year-over-year jump in operating expenses as the company ramped up hiring and spent heavily on research and development. Google also continued to purchase real estate and build more data centers, which led to higher capital expenditure amounting to 16.6% of overall revenue during the quarter vis-à-vis an 11.3% share during the prior-year period.

Investors, however, have been more concerned about acquisition-related expenses, more so because the company has been spending tons of cash on innovative ventures such as drones and driverless cars, which are unlikely to yield profits in the recent future. But then, innovation has always been an integral part of Google, and with its cash reserves amounting to a whopping $61.2 billion, the company can probably afford to indulge in such long-term investments.

The Android effect
The quarter also witnessed a 53% hike in Google's other revenue category, which refers to sales derived from non-advertising-based sources such as apps, games, movies, and music on Google Play, the online marketplace powered by its wildly popular Android operating system.

Incidentally, data from research firm IDC reveals that Google's Android has already managed to capture the top spot, with an overwhelming 78.1% share of the global market for mobile operating systems as of the end of 2013. Apple's (NASDAQ: AAPL  ) iOS, on the other hand, is a distant second place, with a 17.6% share of the market. Apple, which is due to report its latest earnings figures on July 22, has also indulged in a few acquisitions of late, with the most important one being its $3.1 billion purchase of Beats, a maker of upmarket headphones.

Foolish final thoughts
Research firm eMarketer has estimated Google's share of revenues from the U.S.-mobile-based search market to fall by a substantial 19% between 2012-2016. That makes it all the more important for the company to put the brakes on the steady decline in mobile ad rates. At the same time, Google knows that it can always continue to devise strategies that effectively leverage its early mover advantage as the undisputed leader of the global online advertising market.

At the end of the day, Google is still a company with a lot of potential for investors, but it's also one whose progress needs to be closely watched in the near term.

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