Consensus estimates aside, Google (GOOG, GOOGL) issued a very strong third quarter Thursday. The firm reported consolidated revenues of $16.52 billion in the quarter, an increase of 20% on a year-over-year basis. Non-GAAP operating income for the period was $5.36 billion, which compares to non-GAAP operating income of $4.62 billion in last year’s quarter, an increase of 16%. Non-GAAP EPS in the third quarter of $6.35 advanced 12.8% over the $5.63 mark in the prior-year period. Much like that which occurred in eBay’s (EBAY) third quarter, which it reported earlier this week, operating leverage was absent in Google’s business model during the period. Google’s bottom-line growth rate was still solid, but we would have liked to see earnings growth in excess of top-line expansion.
Aggregate paid clicks increased approximately 17% over the third quarter of 2013 and increased approximately 2% sequentially. Though the pace of growth slowed on a year-over-year versus the second quarter, the sequential pace still implies a secular growth story at the search giant. Google continues to be plagued by pricing pressure, as cost per click fell 2% on a year-over-year basis, though it was flat on a sequential basis. We attribute both the slower paid click expansion and pricing pressure to the growing presence of Facebook (FB), and to a lesser extent, Twitter (TWTR). We, however, view Facebook as more of a long-term threat to Google’s advertising dominance than Twitter, which we believe is an ineffective medium for small business expansion. Valuentum’s market tests verified a greater interest in small businesses on Facebook than on Twitter, the latter still used as primarily a news-medium (given character limits).
Google’s operations have a lot of fat, which is why investors shouldn’t be too concerned about the bottom-line numbers. Operating expenses, other than cost of revenues, as a percentage of revenue advanced to 37% in the quarter from 33% in the prior-year period. Research and development, sales and marketing, and general administrative expenses surged during the period. The firm added nearly 3,000 new employees in the past three months. Spending is getting excessive, though we note it represents fat that can be cut. We’d like better scrutiny over spending, but we also acknowledge that Google must continue to innovate to stay ahead of the competition. It’s a delicate balance.
Cash generation is still very healthy at Google. Net cash provided by operating activities totaled ~$6 billion, compared to $5.08 billion in last year’s period. Free cash flow came in at $3.58 billion compared to $2.79 billion in the third quarter of 2013. Google ended the quarter with a whopping $62.18 billion in cash and marketable securities (~17.5% of its market capitalization). We expect shares to trade down after the report, but were not making any changes to the company’s position in the Best Ideas portfolio. Google’s dominance in search, and by extension its competitive position, remains as a strong as ever.