Google Smashes Earnings, and It's Just Getting Started



(GOOG) increasingly finds itself at the center of our digital lives. Besides its sprawling Internet empire, its mobile operating system -- Android -- is quickly becoming the Windows of mobile devices. (Since launching in late 2008, Android has grown its share to 40% of all smartphones this year.) And now, thanks to the launch of its ambitious Google+ service, it aims to take on Facebook in the social networking space.

So it might shock you to learn that analysts had been rushing to trim down their estimates for Google's earnings in recent months.

Well, That Was a Mistake

Last night Google stepped up to the plate and delivered second-quarter earnings good enough to send its shares skyrocketing nearly 13% in after-hours trading.

Excluding stock-compensation and certain income tax effects, the company earned $8.74 per share, significantly ahead of analyst projections of $7.86 in profits per share. Google's sales total also put the pros to shame: After excluding costs paid to partner sites, the search giant had sales of $6.82 billion, which trounced pre-earnings projections of $6.55 billion.

Those results were far ahead of what even the most starry-eyed analyst projected. So what accounts for all the pessimism?

Google's Loose Purse Strings

The main concern surrounding Google's quarter was that its costs were spiraling out of control. All these forays into social media and mobile devices cost quite a bit and don't necessarily offer any immediate revenue.

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Thanks to hiring and new projects, back in April the company issued first-quarter earnings that saw operating expenses climb 82%. In this most recent quarter, they rose 49% compared with the same quarter last year. That level of increased spending cut far deeper into profits than Wall Street expected, and the stock tanked the next day. Heading into last night's report, a number of analysts feared Google's free-spending ways would lead to another earnings whiff.

In addition to cost controls, the amount of money the company collects whenever users click on an ad increased 6% over last quarter. It's a pretty simple equation: lower than expected costs + surprisingly high revenue = huge earnings beat.

Google's Hidden Opportunity

Moving forward, Google's earnings could continue to prove lumpy. The company will continue hiring new engineers left and right and investing in new initiatives that don't always have an immediate payback. That can create quarters in which Google either wildly exceeds or falls significantly short of Wall Street's quarterly profit estimates. However, that's where opportunity lies for investors.

Many investors simply don't understand Google because of the unique way it operates. Take Google's popular Android operating system, which is spreading like wildfire across the mobile world. While Android may be immensely popular, the company gives it away for free, so no direct sales are recorded from its success.

That way of thinking is completely new and foreign to the investing world. Microsoft (MSFT), the titan of operating systems on PCs, has always made money by charging a fee for Windows. Charging a set amount of money for a product is the first thing you learn when setting up your first lemonade stand. You can't just give the stuff away free!

A New Kind of Lemonade Stand

But Google is different. In the long run it actually profits more by giving away Android free of charge. The rationale is pretty simple: Android's just another means of making its search better. Google's not only looking for more people to plug new things into its search bar; it's also looking for better results that advertisers pay more for.

By giving away Android, Google promotes more people buying smartphones. Suddenly, instead of just searching while on your desk at work or home, you're also searching on the go.

That creates more searches.

Also, Google now knows your location, so it can better incorporate a local restaurant when you search for where to eat that night.

That creates better results.

That's part of the reason Google increased the amount of money it collects per advertising click by 6% last quarter; it's getting smarter about how to offer advertising when people search. And here's the best part: There's still a high level of improvement to be achieved by offering more valuable searches. In the long run, initiatives like Android and Google+, which drive Wall Street crazy because they don't offer immediate profits, will contribute far more by strengthening Google's search.

So if you're looking for a way to go one up on Wall Street, look no further than Google. While Wall Street will continue focusing on its quarter-by-quarter results -- resulting in wild swings up and down after earnings -- the long-term trajectory is up. Google's a lot smarter than the "pros" following it.

Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of Microsoft and Google. Motley Fool newsletter services have recommended buying shares of Microsoft and Google.

Originally published