Updated from 7:23 a.m. EDTGoogle ( GOOG) blew out third-quarter earnings targets Thursday, confirming the company's near-term ability to continue a spectacular growth trajectory. Wall Street applauded, sending the shares up nearly 8% to $458.22 in early trading Friday. The Net search giant made $2.62 a share on an adjusted basis on net revenue of $1.87 billion, which reflects payments made to search ad partners. Analysts were looking for EPS of $2.42 on sales of $1.81 billion. "Our third-quarter results are a testament to the strength of our network of advertisers and partners, as well as our continuing focus on users," said CEO Eric Schmidt. "We were particularly pleased with the contributions of our international business in a seasonally weaker quarter." The news comes a couple days after the latest disappointment from rival Yahoo! ( YHOO), whose shares hit a 52-week low Wednesday. The company said revenue at Google-owned sites grew 84% to $1.63 billion, representing 60% of total revenue. Operating expenses, other than cost of revenue, rose to $710 million from about $395 million a year earlier. These operating expenses included $382 million in payroll-related and facilities expenses, $98 million in stock-based compensation, and $50 million in advertising and promotional expenses, of which $14 million was related to certain distribution deals. Third-quarter capital expenditures were $492 million, the majority of which was related to IT infrastructure investments, including data centers, servers and networking equipment.
Google said it continued to expect the growth rate in capital expenditures in 2006 will be "substantially greater" than the revenue growth rate for the year. Operating margins at the company increased to 35% from 33% the prior quarter, while traffic acquisition costs declined to 31% of revenue from 32% in the prior quarter. "Business is very, very good here at Google," said Schmidt in a conference call. He credited the confluence of five factors -- strong user growth, better ad quality, the diversity of its customer base, a "blizzard of new product launches," and partnerships -- as driving the impressive quarter. Google's strong third-quarter performance was more of the same for shareholders, but they'll happily take it. "It has become clear in the last couple of quarters that this company is sort of on auto pilot," says Darren Chervitz, director at the Jacob Internet Fund, which holds Google shares. "At this stage we are no longer concerned about their ability to deliver top-line growth." The remarkable performance follows Yahoo!'s report of a 38% decline in income for the quarter, below what analysts were expecting, and lowered guidance for the full financial year. It also seems to dispel fears among investors that Yahoo!'s woes would afflict Google as well. "When Yahoo! announced weaknesses, we were worried that this was going to be a sign of an industrywide slowdown," says Chervitz. "But this is an early indication that it is not about broader issues -- it is Yahoo!-specific."
Google also defended its growing capital expenditure, arguing that the better service offered by its infrastructure was directly responsible for business growth. "Part of the reason that our results have been so strong in the last year is because a year or two years ago, we 'overinvested' in capital," said Schmidt. "In our model, the capital investment we are making gives us differentially better service quality, better scale, better leverage and we intend to continue that." While Google is already richly valued, some analysts believe the stock still has considerable upside. Trip Chowdhry, an analyst at Global Equities Research, reiterated a $600 price target for the stock prior to Thursday's earnings announcement. He believes the company has the opportunity to dominate the Internet in a way that is reminiscent of Microsoft's ( MSFT) dominance in the personal computer era. "Google continues to change the way we work, interact, educate, and entertain," says Chowdhry. The company also plans on using cash for future acquisitions, since it considers its stock undervalued. Earlier this month, the company announced a $1.6 billion acquisition for video sharing site YouTube in a deal which was paid for in Google stock. Investors remain concerned that the acquisition may expose Google to costly lawsuits as YouTube contains copyrighted material. "The true cost of that acquisition will be several billion dollars. The $1.6 billion was only a down payment," says Chervitz.
But Schmidt was adamant in maintaining that Google would be legally correct in carrying out its policy of only removing copyrighted material after it has been notified about the content by the content's owner. The policy places the onus of identifying the content and bringing it to Google's attention on the content owner -- a tall order given the vast amount of material uploaded to YouTube everyday. "We are relying on the Digital Millennium Copyright Act as it is being imposed by law, and there are not a lot of shades of gray in how it works. There's a set of procedures for take down. If you operate under this, companies have a safe harbor," Schmidt said. "So, whether people like it or not, it is the law of the land and we absolutely operate by it." Analysts also have been concerned that buying YouTube would lead to higher capital spending, because Google would have to buy infrastructure to support the rapidly growing site in the resource-intensive video arena. However, Larry Page, company co-founder and head of products, dismissed these concerns, saying the YouTube acquisition would "not be hugely material to our capital spending vs. all the other things that we are doing." Schmidt added that Google was the "beneficiary of huge economies of scale." Google also said its overseas efforts were panning out well, and noted that international ad sales accounted for 44% of third-quarter revenue, as compared with 39% the year before.