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Happy Google investors may not be good for the company's long-term vision

By Kevin Kelleher , written on July 17, 2015

From The Money Desk

For the first time in a while, Google investors are thrilled with its financial health.

They sent Google shares rising as much as 14 percent to a record high of $683 in the after-hours trading that followed Google's second-quarter earnings report. The reason for the glee, though, may not be good for the long-term vision Google has always pursued.

For the previous four quarters, Google's financials came up short with profits that were below what Wall Street analysts had been expecting. On Thursday, Google said its net income last quarter came in at $6.99 a share, above the $6.70 a share consensus estimate. Revenue after traffic-acquisition costs rose 13 percent to $14.4 billion, squeaking above $14.3 billion target.

Those numbers were enough to send Google's stock rising 7 percent right away. That rally says as much about Google's surprisingly strong quarter as it does about the low bar of expectations its investors have set for the past year. For many years, Google routinely surpassed the Wall Street consensus, but that changed once Google began grappling with a migration away from search ads on PCs, falling cost-per-click rates, and a constant and growing competitor in Facebook.

Once the conference call to discuss the earnings report began, Google shares continued to rally higher. Google's new CFO Ruth Porat, who joined Google in May after holding the same title at Morgan Stanley, began talking about a focus on costs. Porat’s hire had been seen as a transition to a new era of tighter spending at Google. Her comments underscored that this indeed seems to be the case.

“We are focused every day on developing big new opportunities across a wide range of businesses,” Porat said. “We will do so with great care regarding resource allocation.” Google's costs and operating expenses fell to 66 percent of revenue last quarter, down from 68 percent a year earlier and the lowest ratio in nearly two years. As a result, its operating margin has risen steadily over the past four quarters to 27 percent from 23 percent.

Just as notable is where the spending is declining. Research and development expenses remain steady around 16 percent of revenue, while cost of revenue has fallen to 37 percent from 40 percent last fall, thanks largely to lower traffic-acquisition costs. Capital spending fell 5 percent to $2.5 billion from a year ago. By trimming back spending, Google's free cash flow grew 50 percent to $4.5 billion. Google's founders have long talked about the company having a long-term vision – and while they don't mention the 300-year plan as much as they used to, Google has always plotted its future beyond today's core search and digital-ad operations to include moonshot projects like self-driving cars and life sciences. Porat stressed that the company was not abandoning these areas as it pushes to become more cost-conscious.

At the same time, Google is facing the increased pressure that investors apply to aging tech giants to boost revenue and income growth quarter after quarter, with the aim of eventually returning cash to investors. Asked about the possibility of Google paying dividends or borrowing money to buy back shares from investors, Porat was noncommittal, saying only that Google will manage its balance sheet to maximize all opportunities.

While the shift to a more frugal attitude is welcome to investors, and even necessary for the company's medium-term success, it marks a step away from the startup mentality that Google has tried to embrace and cling to from its earliest days. Uber has also been investing heavily in self-driving cars, but its private investors seem content to wait and see what that will bring in a few years, rather than agitating for tighter spending and an eventual dividend.

All of this is only likely to add to the perception that Google is turning into Microsoft. But Porat and Chief Business Officer Omid Kordestani tried to make the case that there is still plenty of growth left in its core operations. Several bullish metrics were offered on the growth of YouTube, which now has a billion users and saw its "watch time" rise 60 percent year-over-year and the number of advertisers increase by 40 percent. Google said the average YouTube mobile session now lasts about 40 minutes.

That may alleviate some concern about the impact Facebook's aggressive push into video is having on YouTube's growth. But at the same time, it's becoming clear that the real culprit in the persistent decline in cost per clicks – perhaps the most closely watched metric from Google's quarterly earnings report – has not been necessarily lower prices for mobile ads or even CPC's served to PC devices, but the TrueView ads that appear at the beginning of YouTube videos, which many users choose to ignore. Google only charges advertisers for TrueView ads when users are distracted enough by them to watch.

Google argued that those ads are slowly beginning to win over more user engagement, which could allow Google to charge higher rates on them in the future. While it may come as a relief to some investors that CPCs on mobile ads are not as bad off as they feared, the reality is that overall CPC rates are nonetheless declining: down 4 percent from the previous quarter and down 11 percent from a year ago.

All in all, the key takeaway from Google's report may be that its efforts to manage an ever-evolving digital-advertising landscape are working better than many had expected. Google bought YouTube a decade ago and yet it's still tweaking its formula for selling ads on the platform. That long-term approach to balancing user engagement with revenue is similar to what Facebook has done on mobile feeds and Instagram.

The difference is that Facebook is seeing its revenue grow several times faster than Google is. That gives Facebook a lot of slack that Google is not afforded. So Google is having to trim spending on its legendary moonshots and squeeze more from its older operations. In the meantime, its 300-year plan is losing more and more ground to the three-month forecast.