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Two Red Flags in Google Inc (GOOG)’s Q2 Earnings Report

Google Inc. (GOOG)It’s useless to evaluate a company’s performance without taking valuation into consideration. For this reason, I hold Google Inc (NASDAQ:GOOG) to very high standards. I have to — it trades at about 27.5 times earnings. With such lofty expectations baked into the stock price, every quarter I’m on the lookout for red flags. On that note, two negative trends continue to force me to face the stock’s valuation with caution.

Google’s cost-per-click continues to decline
Though Google Inc (NASDAQ:GOOG)’s driverless car, Google Glass, and its smartphone and tablet hardware are all important and entertaining projects, they still represent a very small portion of Google’s business. Advertising is where Google makes its money — less than 10% of revenue comes from other sources.

To assess the profitability of Google’s ad business, it’s helpful to take a look at traffic acquisition costs and cost-per-click.

Traffic acquisition costs, or the portion of revenue Google Inc (NASDAQ:GOOG) shares with its advertising partners, remained unchanged from the year-ago quarter at 25% of revenue in Q2. In fact, traffic acquisition costs are just 100 basis points lower than they were in Q2 of 2011.

But Google’s cost-per-clicks, or CPCs, aren’t looking as solid. CPCs refer to the average CPC that advertisers are paying Google when someone clicks on their ad. The more advertisers pay, the more revenue Google gets to collect per click. As Google migrates to an increasingly mobile environment, the company’s CPCs have been declining. In fact, Google Inc (NASDAQ:GOOG)’s CPCs have posted year-over-year declines in each of the past seven quarters.

Source: SEC filings.

Though the sequential decline in CPCs of 2% was smaller than last quarter’s sequential decline of 4%, it’s still a decline nevertheless. This is definitely a trend to keep a close eye on. With more than 90% of revenue coming from advertising, declines in revenue from cost-per-clicks has material effects on Google’s bottom line.

A shifting revenue mix is hurting operating margins
Google Inc (NASDAQ:GOOG)’s business has evolved dramatically over the last five years. Beyond the inevitable shift to mobile devices, Google has entered the lower-margin hardware business with the acquisition of Motorola and the launch of Google-branded smartphones, tablets, and laptops.

As long as these projects are providing investors with excess returns, they are definitely beneficial to shareholders. But Google’s shifting revenue mix presents a reality investors can’t ignore: The shifting mix means lower operating margins and this will make year-over-year comps in operating income tougher than they were in the past.

In Google’s second quarter, non-GAAP operating income came in at 28% of revenues, 500 basis points lower than the 33% operating margin the company reported in the year-ago quarter.

Valuation matters
Year to date, Google shareholders have been rewarded handsomely. Shares are up about 27% — even after a second-quarter report that came in below expectations. Though that’s great for shareholders, it has changed the game for prospective buyers. Now, investors looking to buy Google shares have to be willing to fork out a considerable premium for the stock.

Using a reverse discounted cash flow valuation for Google Inc (NASDAQ:GOOG) stock, the assumed growth rate by the market for Google’s free cash flow going forward is about 20%. As Google’s operating margins and CPCs continue to decline, I would think twice before I bought Google stock. Though the stock might not be grossly overvalued, it at least seems fairly valued.

The article 2 Red Flags in Google’s Q2 Earnings Report originally appeared on Fool.com and is written by Daniel Sparks.

Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Google.

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