Google Margin Decline: Impact on Stock

Google (GOOG) recently announced that its EBITDA margins (a measure of profitability) shrank from 54.3% in the first quarter of 2010 to 51.7% in the second quarter. Google executives attributed the margin decline to increasing headcount leading to higher R&D and SG&A costs, as well as to revenue losses related to the European debt crisis.

We believe that Google's margin decline will be temporary, and will not impact the $683 Trefis price estimate for Google's stock. Our analysis follows below.

Google

Downside impact

Google competes with Microsoft ( MSFT), Yahoo! ( YHOO) and AOL ( AOL) in the search advertising market. We estimate that Google's search advertising business constitutes about 72% of the $683 Trefis price estimate for Google's stock.

We expect Google's EBITDA margins in the search business to decline slightly from around 60% last year to 59% in 2010, and then stabilize over the long term. We believe that Google will continue to gain search market share over our forecast period and that growing share, combined with a broader economic recovery leading to higher online ad spend, will help Google's margins recover.

However, if margin declines are not temporary and declines to around 50% by the end of Trefis forecast period, there could be a downside of 10% to our estimate. Drag the line in the chart below to modify our EBITDA margin forecast and see its impact on Google's stock price.

Why Google's margins shrank

1. Headcount increase

Google added 1,200 employees in the second quarter of 2010, including 300 employees of AdMob, a mobile advertising company that Google acquired during the quarter. The headcount increase was an increase of around 6% in the second quarter of 2010 over around 20,600 in the first quarter. These additions increased Google's operating costs and squeezed margins.

In the long run, we believe these additions will allow Google to keep innovating and increase its share of an increasingly competitive search market.

2. European debt crisis

Google gets about one-third of its revenues from Europe. The recent European debt crisis hurt Google's search advertisement revenues. During times of economic uncertainty, companies tend to cut their marketing budgets which includes online ad spend. As a result, overall revenues increased by only 0.7% in the second quarter of 2010 over the first quarter of 2010. Slower revenue growth combined with rising expenses led to decline in margins.

However, we believe that Google's European revenues will recover as the sovereign debt crisis subsides.

You can see the complete $683 Trefis Price estimate for Google's stock here.

Trefis is a financial community structured around trends, forecasts and insights related to some of the most popular stocks in the U.S.

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