April 20, 2007 / 9:30 PM / 13 years ago

Lower taxes loom large in Google earnings surprise

SAN FRANCISCO (Reuters) - Google Inc.’s (GOOG.O) latest quarterly profit beat expectations by a wide margin yet again, but a lower tax bill played a big role this time, calling into question how sustainable such surprises may be.

The logo of Google Inc. is seen outside their headquarters building in Mountain View, California August 18, 2004. Google Inc. reported on Thursday its quarterly net profit rose 69 percent, topping expectations, driven by market share gains in its Web search business, sending its stock up 2.8 percent after-hours. REUTERS/Clay McLachlan is seen outside their headquarters building in Mountain View, California August 18, 2004. Google Inc. reported on Thursday its quarterly net profit rose 69 percent, topping expectations, driven by market share gains in its Web search business, sending its stock up 2.8 percent after-hours. REUTERS/Clay McLachlan

The immediate issue for holders of the leading Internet stock following the quarterly report was how much of the profit surprise, which investors have come to demand from such highly valued shares, was tied to an unexpectedly lower tax rate.

Google posted 69 percent first-quarter profit growth, far better than an average Wall Street analyst prediction of a 45 percent rise. The effective tax rate was 26 percent, not the 30 percent rate the company steered analysts to expect this year.

“Google did do a great job on execution, but the lowered tax rate helped Google generate an impressive earnings growth,” Trip Chowdhry, an analyst with Global Equities Research, wrote in a research note following Google’s report.

“Taxes are a wildcard for this company,” another analyst, who declined to be identified, agreed.

Beyond questions of whether an accounting factor like taxes rather than organic growth is responsible for propping up Wall Street expectations is the long-term trend toward an ever-narrower gap between results and expectations.

Reuters Estimates data shows the level by which Google beats consensus profit forecasts has shrunk to about 10 percent from levels of 15 percent or more up until a year ago. Revenue surprises have steadied to 2 percent to 3 percent above expectations, versus 7 percent to 8 percent in prior years.

“When you have a company that finds itself not substantially exceeding expectations, you are in a situation where Wall Street has effectively caught up with what the company is doing,” Dinosaur Research analyst David Garrity said. “In the future, you can’t expect the same share gains.”

The stock enjoyed a spectacular rise from $100 at Google’s initial public offering in August 2004 to more than $500 in late 2006 on the back of a nearly unblemished track record of delivering quarterly revenue and earnings above expectations.

Investors pushed up the stock 2.3 percent to $482.48 on Friday, brushing aside questions about the size of the earnings surprise and focusing instead on how Google is growing three- to four-times faster than rivals in a very competitive market.

TAX RETURN

By Chowdhry’s calculation, Google’s profit, excluding stock option expenses, would be 32 cents lower if not for the lower-than-expected tax rate, meaning the much-sought-after profit surprise would have been 6 cents, not 38 cents.

Other Google analysts said the tax rate was important but not as large a factor as Chowdhry states. Garrity calculates the impact of the lower tax rate as adding 22 cents to profit.

Global Crown Capital analyst Martin Pyykkonen puts the tax effect at 17 cents, a little under half the amount by which Google appeared to beat consensus expectations. Citigroup analyst Mark Mahaney estimated the tax effect at 15 cents.

The Web search leader, which has a policy of not giving Wall Street financial guidance, started out the year by telling analysts to expect a tax rate of 30 percent or so in 2007.

Excluding stock-option costs, Google posted a first-quarter profit of $3.68 a share, up from the $2.29 a year ago. According to Reuters Estimates, Wall Street analysts, on average, had predicted $3.31 per share on the same basis.

Tax questions and the narrowing trend of positive financial surprises notwithstanding, Merrill Lynch raised its Google stock price target to $590 from $560, Banc of America moved to $620 from $601 and Lehman raised its target to $610 from $560.

“We believe Google continues to distance itself from other large-capitalization Internet (stocks) in terms of operational performance, strategic vision and profitability,” Lehman Brothers analyst Douglas Anmuth said in a research report.

Additional reporting by Jim Finkle

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