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GOOGLE INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Overview Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products and provide services that improve the lives of billions of people globally. Our mission is to organize the world's information and make it universally accessible and useful. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world. Google generates revenues primarily by delivering relevant, cost-effective online advertising. Businesses use our AdWords program and AdSense program to promote their products and services with advertising on both Google-owned properties and publishers' sites across the web. In January 2014, we entered into an agreement with Lenovo Group Limited (Lenovo) providing for the disposition of the Motorola Mobile business. The transaction is expected to close in the fourth quarter of 2014. Financial results of Motorola Mobile are presented as "Net income (loss) from discontinued operations" on the Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2014; and assets and liabilities of Motorola Mobile to be disposed of are presented as "Assets held for sale" and "Liabilities held for sale" on the Consolidated Balance Sheet as of September 30, 2014, respectively. The Motorola Mobile business is focused on mobile wireless devices and related products and services and generates revenues primarily by selling hardware products. In December 2012, we entered into an agreement for the disposition of the Motorola Home business. The transaction closed on April 17, 2013. Financial results through the date of divestiture related to Motorola Home were included within "Net income (loss) from discontinued operations" on the Consolidated Statements of Income for the three and nine months ended September 30, 2013. The Motorola Home business was focused on technologies and devices that provide video entertainment services to consumers by enabling subscribers to access a variety of interactive digital television services. Trends in Our Businesses Advertising transactions continue to shift from offline to online as the digital economy evolves. This has contributed to the rapid growth of our business since inception, resulting in substantially increased revenues, and we expect that our business will continue to grow. However, our revenue growth rate has generally declined over time, and it could do so in the future as a result of a number of factors, including increasing competition, our investments in new business strategies, products, services, and technologies, changes in our product mix, shifts in the geographic mix of our revenues, query growth rates and how users make queries, challenges in maintaining our growth rate as our revenues increase to higher levels, and the evolution of the online advertising market, including the increasing variety of online platforms for advertising, and other markets in which we participate. Our users are increasingly connected to the internet and using multiple devices to access our products and services, a trend that has increased our global search queries and changed our platform mix. We expect that our revenue growth rate will continue to be affected by evolving consumer preferences, as well as by advertising trends, the acceptance by users of our products and services as they are delivered on diverse devices, and our ability to create a seamless experience for both users and advertisers in this multi-screen environment. The main focus of our advertising programs is to help businesses reach people in the moments that matter across all devices with smarter ads that are relevant to their intent and context, reflecting our commitment to constantly improve their overall web experience. As a result, we expect to continue to take steps to improve the relevance of the ads displayed on our websites and our Google Network Members' websites. These steps include not displaying ads that generate low click-through rates or that send users to irrelevant or otherwise low-quality websites, updating our advertising policies and ensuring their compliance, and terminating our relationships with those Google Network Members whose websites do not meet our quality requirements. We may also continue to take steps to reduce the number of accidental clicks by our users. These steps could negatively affect the growth rate of our revenues. Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely 30-------------------------------------------------------------------------------- Table of Contents continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenues, as well as aggregate paid clicks and average cost-per-click growth rates. The operating margin we realize on revenues generated from ads placed on our Google Network Members' websites through our AdSense program is significantly lower than the operating margin we realize from revenues generated from ads placed on our websites because most of the advertiser fees from ads served on Google Network Members' websites are shared with our Google Network Members. For the past five years, growth in advertising revenues from our websites has generally exceeded that from our Google Network Members' websites. This trend has had a positive impact on our operating margins, and we expect that this will continue for the foreseeable future, although the relative rate of growth in revenues from our websites compared to the rate of growth in revenues from our Google Network Members' websites may vary over time. Also, the margins on advertising revenues from mobile phones and other newer advertising formats are generally lower than those from desktop computers and tablets. We expect this trend to continue to pressure our margins, particularly if we fail to realize the opportunities we anticipate with the transition to a dynamic multi-screen environment. We conduct our Motorola Mobile business in highly competitive markets, facing both new and established competitors. The markets for many of our products are characterized by rapidly changing technologies, frequent new product introductions, changing consumer trends, short product life cycles, consumer loyalty and evolving industry standards. Market disruptions caused by new technologies, the entry of new competitors, consolidations among our customers and competitors, changes in regulatory requirements, changes in economic conditions, supply chain interruptions, or other factors, can introduce volatility into our businesses. Meeting all of these challenges requires consistent operational planning and execution and investment in technology, resulting in innovative products that meet the needs of our customers around the world. From an overall business perspective, we continue to invest aggressively in areas of strategic focus, our systems, data centers, real estate and facilities, information technology infrastructure, and employees. We expect to continue to hire aggressively for the remainder of 2014 and provide competitive compensation programs to our employees. Our full-time employee headcount was 46,421 (which included 4,259 headcount from Motorola Mobile) at September 30, 2013, and 55,030 (which included 3,466 headcount from Motorola Mobile) at September 30, 2014. Acquisitions will also remain an important component of our strategy and use of capital. We expect our cost of revenues will increase in dollars and may increase as a percentage of revenues in future periods, primarily as a result of forecasted increases in traffic acquisition costs, manufacturing and inventory-related costs, data center costs, content acquisition costs, credit card and other transaction fees, and other costs. In particular, traffic acquisition costs as a percentage of advertising revenues may increase in the future if we are unable to continue to improve the monetization or generation of revenues from traffic on our websites and our Google Network Members' websites. As we expand our advertising programs and other products to international markets, we continue to increase our exposure to fluctuations in foreign currency to U.S. dollar exchange rates. We have a foreign exchange risk management program that is designed to reduce our exposure to fluctuations in foreign currency exchange rates. However, this program will not fully offset the effect of fluctuations on our revenues and earnings. Other revenues consist of non-advertising revenues including licensing, hardware, and digital content revenues. We expect other revenues to continue to grow. However, our operating margin on other revenues is generally lower than that on advertising revenues. Results of Operations We completed our acquisition of Motorola on May 22, 2012 (the acquisition date). In December 2012, we entered into an agreement with Arris and certain other persons providing for the disposition of the Motorola Home business. The transaction closed on April 17, 2013. Financial results of Motorola Home were included in "Net income (loss) from discontinued operations" for the three and nine months ended September 30, 2013. In January 2014, we entered into an agreement with Lenovo providing for the disposition of the Motorola Mobile business. The transaction is expected to close in the fourth quarter of 2014. Financial results of Motorola Mobile are presented as "Net income (loss) from discontinued operations" on the Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2014; and assets and liabilities of Motorola Mobile to be disposed of are presented as "Assets held for sale" and "Liabilities held for sale" on the Consolidated Balance Sheet as of September 30, 2014, respectively. 31-------------------------------------------------------------------------------- Table of Contents The following table presents our historical operating results as a percentage of revenues for the periods presented: Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Consolidated Statements of Income Data: Revenues 100 % 100 % 100 % 100 % Costs and expenses: Cost of revenues 39.3 40.5 39.5 39.2 Research and development 13.2 16.1 13.1 14.7 Sales and marketing 11.8 12.6 11.7 12.0 General and administrative 8.4 8.3 8.1 8.8 Total costs and expenses 72.7 77.5 72.4 74.7 Income from operations 27.3 22.5 27.6 25.3 Interest and other income, net 0.1 0.8 0.9 1.3 Income from continuing operations before income taxes 27.4 23.3 28.5 26.6 Provision for income taxes 4.4 5.2 4.7 5.4 Net income from continuing operations 23.0 18.1 23.8 21.2 Net income (loss) from discontinued operations (1.4 ) (1.1 ) 0.2 (1.0 ) Net income 21.6 % 17.0 % 24.0 % 20.2 % RevenuesThe following table presents our revenues, by revenue source, for the periods presented (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Advertising revenues: Websites $ 9,376 $ 11,252 $ 26,884 $ 32,656 Network Members' websites 3,148 3,430 9,603 10,251 Total advertising revenues 12,524 14,682 36,487 42,907 Other revenues 1,230 1,841 3,325 4,991 Total revenues $ 13,754 $ 16,523 $ 39,812 $ 47,898 32-------------------------------------------------------------------------------- Table of Contents The following table presents our revenues, by revenue source, as a percentage of revenues for the periods presented: Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Advertising revenues: Websites 68.2 % 68.1 % 67.5 % 68.2 % Network Members' websites 22.9 % 20.8 % 24.1 % 21.4 % Total advertising revenues 91.1 % 88.9 % 91.6 % 89.6 % Websites revenues as % of advertising revenues 74.9 % 76.6 % 73.7 % 76.1 % Network Members' websites revenues as % of advertising revenues 25.1 % 23.4 % 26.3 % 23.9 % Other revenues 8.9 % 11.1 % 8.4 % 10.4 % Our revenues increased $2,769 million and $8,086 million from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014. This increase resulted primarily from an increase in advertising revenues generated by Google websites and an increase in other revenues, and to a lesser extent, an increase in advertising revenues generated by Google Network Members' websites. The increase in advertising revenues for Google websites and Google Network Members' websites resulted primarily from an increase in the number of aggregate paid clicks through our advertising programs. The increase in other revenues was mainly driven by growth in revenues from digital content and licensing. The number of aggregate paid clicks increased approximately 17% and 22% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. The increase in the number of paid clicks generated through our advertising programs was due to certain monetization improvements including new and richer ad formats, an increase in aggregate traffic across all platforms, the continued global expansion of our products, advertisers, and user base, as well as an increase in the number of Google Network Members, partially offset by certain advertising policy changes. This impact of the increased paid clicks on our revenue growth was partially offset by a decrease in the average cost-per-click paid by our advertisers. The average cost-per-click decreased approximately 2% and 6% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. The decrease in the average cost-per-click paid by our advertisers was driven by various factors, such as the introduction of new products and changes in property mix, platform mix, geographical mix and foreign currency exchange impact. Paid clicks on Google websites, which include clicks related to ads served on Google owned and operated properties across different geographies and form factors, including search, YouTube engagement ads like TrueView, and other owned and operated properties like Maps and Finance, increased approximately 24% and 31% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. Paid clicks on Google Network Members' websites, which include clicks related to ads served on non-Google properties participating in our AdSense for Search, AdSense for Content, and AdMob businesses, increased approximately 2% and 7% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. In addition, cost-per-click on Google websites decreased approximately 4% and 7% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. Cost-per-click on Google Network Members' websites decreased approximately 4% and 10% from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014, respectively. The rate of change in paid clicks and average cost-per-click on Google websites and Google Network Members' websites, and their correlation with the rate of change in revenues, has fluctuated and may fluctuate in the future because of various factors, including the revenue growth rates on our websites compared to those of our Google Network Members, advertiser competition for keywords, changes in foreign currency exchange rates, seasonality, the fees advertisers are willing to pay based on how they manage their advertising costs, changes in advertising quality or formats, and general economic conditions. In addition, traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels also contributes to these fluctuations. Changes in paid clicks and average cost-per-click on Google websites and Google Network Members' websites may not be indicative of our performance or advertiser experiences in any specific geographic market, vertical, or industry. 33-------------------------------------------------------------------------------- Table of Contents Improvements in our ability to monetize increased traffic primarily relate to enhancing the end user experience, including providing end users with ads that are more relevant to their search queries or to the content on the Google Network Members' websites they visit. For instance, these improvements include displaying advertiser-nominated images that are relevant to the user query and creating a more engaging user shopping experience by enhancing search ads to include richer product information, such as product image, price, and merchant name. We believe that the increase in the number of paid clicks on Google websites and Google Network Members' websites is substantially the result of our commitment to improving the relevance and quality of both our search results and the advertisements displayed, which we believe results in a better user experience, which in turn results in more searches, advertisers, Google Network Members, and other partners. Other revenues increased $611 million and $1,666 million from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014 and also increased as a percentage of total revenues. The increase was primarily due to growth of our digital content, such as apps, music and movies. The increase in other revenues was also attributed to an increase in licensing revenues from the three months ended September 30, 2013 to the three months ended September 30, 2014. Revenues by Geography The following table presents our domestic and international revenues as a percentage of total revenues, determined based on the billing addresses of our customers: Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) United States 44 % 42 % 45 % 42 % United Kingdom 10 % 10 % 10 % 10 % Rest of the world 46 % 48 % 45 % 48 % The growth in revenues from the rest of the world as a percentage of total revenues from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014 resulted largely from increased acceptance of our advertising programs, and our continued progress in developing localized versions of our products for international markets. Foreign Exchange Impact on Revenues The general weakening of the U.S. dollar relative to certain foreign currencies (primarily the British pound and Euro) from the three months ended September 30, 2013 to the three months ended September 30, 2014 had a favorable impact on our international revenues, which was partially offset by the general strengthening of the U.S. dollar relative to other foreign currencies (primarily Japanese yen). Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $121 million or 7% lower and our revenues from the rest of the world would have been approximately $15 million higher for the three months ended September 30, 2014. This is before consideration of hedging gains of $10 million recognized in revenues from the rest of the world in the three months ended September 30, 2014. The general weakening of the U.S. dollar relative to certain foreign currencies (primarily the British pound and Euro) from the nine months ended September 30, 2013 to the nine months ended September 30, 2014 had a favorable impact on our international revenues, which was partially offset by the general strengthening of the U.S. dollar relative to other foreign currencies (primarily the Japanese yen, Australian dollar, and Brazilian real). Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $315 million or 7% lower and our revenues from the rest of the world would have been approximately $254 million or 1% higher in the nine months ended September 30, 2014. This is before consideration of hedging gains of $24 million recognized in revenues from the rest of the world in the nine months ended September 30, 2014. Although we expect to continue to make investments in international markets, these investments may not result in an increase in our international revenues as a percentage of total revenues in the remainder of 2014 or thereafter. See Note 14 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information about geographic areas. 34-------------------------------------------------------------------------------- Table of Contents Costs and Expenses Cost of Revenues Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts paid to our Google Network Members under AdSense arrangements and to certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points) or otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share and fixed fee arrangements with our Google Network Members and distribution partners. Certain distribution arrangements require us to pay our partners based on a fee per access point delivered and not exclusively -- or at all -- based on revenue share. These fees are non-refundable. Further, these arrangements are terminable at will, although under the terms of certain contracts we or our distribution partners may be subject to penalties in the event of early termination. We recognize fees under these arrangements over the estimated useful lives of the access points to the extent we can reasonably estimate those lives and they are one year or longer, or based on any contractual revenue share, if greater. Otherwise, the fees are charged to expense as incurred. The estimated useful life of the access points is based on the historical average period of time they generate traffic and revenues. Cost of revenues also includes the expenses associated with the operation of our data centers, including depreciation, labor, energy, and bandwidth costs; hardware inventory costs; credit card and other transaction fees related to processing customer transactions; amortization and impairment of acquisition-related intangible assets; and content acquisition costs. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. In a number of these arrangements, we display ads on the pages of our websites from which the content is viewed and share most of the fees these ads generate with the content providers. We also license content on the pages of our websites from which the content is sold and share most of the fees these sales generate with content providers. To the extent we are obligated to make guaranteed minimum revenue share payments to our content providers, we recognize as content acquisition costs the contractual revenue share amount or the amount determined on a straight-line basis, whichever is greater, over the term of the agreements. The following tables present our cost of revenues and cost of revenues as a percentage of revenues, and our traffic acquisition costs and traffic acquisition costs as a percentage of advertising revenues, for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Cost of revenues $ 5,409 $ 6,695 $ 15,740 $ 18,770 Cost of revenues as a percentage of revenues 39.3 % 40.5 % 39.5 % 39.2 % Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Traffic acquisition costs related to AdSense arrangements $ 2,217 $ 2,421 $ 6,806 $ 7,208 Traffic acquisition costs related to distribution arrangements 755 927 2,141 2,665 Traffic acquisition costs $ 2,972 $ 3,348 $ 8,947 $ 9,873 Traffic acquisition costs as a percentage of advertising revenues 23.7 % 22.8 % 24.5 % 23.0 % Cost of revenues increased $1,286 million and $3,030 million from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014. The increase was partially due to increases in traffic acquisition costs of $376 million and $926 million from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014 resulting from more advertiser fees generated through our AdSense program driven primarily by an increase in advertising revenues, as well as more distribution fees paid and more fees paid for additional traffic directed to our websites. In addition, the increase was also driven by an impairment charge of $378 million recognized during the three months ended September 30, 2014 related to a patent licensing royalty asset acquired in connection with the Motorola acquisition. The remaining increase was primarily driven by an 35-------------------------------------------------------------------------------- Table of Contents increase in data center costs, content acquisition costs as a result of increased activities related to YouTube and digital content, and revenue share payments to mobile carriers and original equipment manufacturers (OEMs). The decrease in aggregate traffic acquisition costs as a percentage of advertising revenues was primarily a result of a shift of mix between Google website revenue and Google Network Members' websites revenue. We expect cost of revenues will increase in dollar amount and may increase as a percentage of total revenues in the remainder of 2014 and in future periods, primarily as a result of increases in traffic acquisition costs, data center costs, hardware inventory costs, content acquisition costs, credit card and other transaction fees, and other costs. Traffic acquisition costs as a percentage of advertising revenues may fluctuate in the future based on a number of factors, including the following: • The relative growth rates of revenues from our websites and from our Google Network Members' websites. • Whether we are able to enter into more AdSense arrangements that provide for lower revenue share obligations or whether increased competition for arrangements with existing and potential Google Network Members results in less favorable revenue share arrangements. • Whether we are able to continue to improve the monetization of traffic on our websites and our Google Network Members' websites. • The relative growth rates of expenses associated with distribution arrangements and the related revenues generated, including whether we share with certain existing and new distribution partners proportionately more of the aggregate advertising fees that we earn from paid clicks derived from search queries these partners direct to our websites. Research and Development The following table presents our research and development expenses, and research and development expenses as a percentage of revenues, for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Research and development expenses $ 1,821 $ 2,655 $ 5,204 $ 7,019 Research and development expenses as a percentage of revenues 13.2 % 16.1 % 13.1 % 14.7 % Research and development expenses consist primarily of compensation and related costs for personnel responsible for the research and development activities relating to new and existing products and services, as well as depreciation and equipment-related costs. We expense research and development costs as incurred. Research and development expenses increased $834 million and also increased as a percentage of revenues from the three months ended September 30, 2013 to the three months ended September 30, 2014. The increase was primarily due to an increase in labor and facilities-related costs of $357 million, largely as a result of a 29% increase in research and development headcount, an increase in stock-based compensation expense of $230 million, an increase in depreciation and equipment-related expenses of $122 million, and an increase in professional service fees of $112 million. Research and development expenses increased $1,815 million and also increased as a percentage of revenues from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. The increase was primarily due to an increase in labor and facilities-related costs of $874 million, largely as a result of a 26% increase in research and development headcount, an increase in stock-based compensation expense of $394 million, an increase in depreciation and equipment-related expenses of $258 million, and an increase in professional service fees of $257 million. We expect that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2014 and future periods because we expect to continue to invest in building the necessary employee and system infrastructure required to support the development of new, and to improve existing, products and services. 36-------------------------------------------------------------------------------- Table of Contents Sales and Marketing The following table presents our sales and marketing expenses, and sales and marketing expenses as a percentage of revenues, for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Sales and marketing expenses $ 1,628 $ 2,084 $ 4,646 $ 5,754 Sales and marketing expenses as a percentage of revenues 11.8 % 12.6 % 11.7 % 12.0 % Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in customer service, sales, and sales support functions, as well as advertising and promotional expenditures. Sales and marketing expenses increased $456 million and also increased slightly as a percentage of revenues from the three months ended September 30, 2013 to the three months ended September 30, 2014. The increase was primarily due to an increase in labor and facilities-related costs of $190 million, largely as a result of a 15% increase in sales and marketing headcount, an increase in advertising and promotional expenses of $160 million, an increase in stock-based compensation expense of $42 million, and an increase in professional services fees of $29 million. Sales and marketing expenses increased $1,108 million and also increased slightly as a percentage of revenues from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. The increase was primarily due to an increase in advertising and promotional expenses of $464 million, an increase in labor and facilities-related costs of $430 million, largely as a result of a 12% increase in sales and marketing headcount, an increase in stock-based compensation expense of $104 million, and an increase to professional services fees of $70 million. We expect that sales and marketing expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2014 and future periods, as we expand our business globally, increase advertising and promotional expenditures in connection with new and existing products, and increase the level of service we provide to our advertisers, Google Network Members, and other partners. General and Administrative The following table presents our general and administrative expenses, and general and administrative expenses as a percentage of revenues, for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) General and administrative expenses $ 1,135 $ 1,365 $ 3,248 $ 4,258 General and administrative expenses as a percentage of revenues 8.4 % 8.3 % 8.1 % 8.8 % General and administrative expenses consist primarily of compensation and related costs for personnel and facilities, and include costs related to our facilities, finance, human resources, information technology and legal organizations, as well as fees for professional services. Professional services are principally comprised of outside legal, audit, information technology consulting, and outsourcing services. General and administrative expenses also include amortization of certain acquisition-related intangible assets. General and administrative expenses increased $230 million and remained flat as a percentage of revenues from the three months ended September 30, 2013 to the three months ended September 30, 2014. The increase in expenses was primarily due to an increase in stock-based compensation expense of $91 million, an increase in labor and facilities-related costs of $86 million, largely as a result of a 25% increase in general and administrative headcount, and an increase in depreciation and amortization expense of $27 million. General and administrative expenses increased $1,010 million and also increased as a percentage of revenues from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. The increase was primarily due to an increase in labor and facilities-related costs of $324 million, largely as a result of a 23% increase 37-------------------------------------------------------------------------------- Table of Contents in general and administrative headcount, an increase in professional service fees and legal expenses of $293 million, an increase in stock-based compensation expense of $200 million, and an increase in depreciation and amortization expense of $50 million. As we expand our business and incur additional expenses, we expect general and administrative expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2014 and in future periods. Stock-Based Compensation The following table presents our aggregate stock-based compensation expense reflected in our consolidated results from continuing operations for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Stock-based compensation $ 856 $ 1,255 $ 2,254 $ 2,974 Stock-based compensation as a percentage of revenues 6.2 % 7.6 % 5.7 % 6.2 % Stock-based compensation increased $399 million and $720 million from the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2014. These increases were primarily due to additional stock awards issued to existing and new employees. We estimate stock-based compensation for Google employees to be approximately $4.2 billion in 2014 and $9.2 billion thereafter related to stock awards granted as of September 30, 2014. This estimate does not include expenses to be recognized related to employee stock awards that are granted after September 30, 2014. In addition, to the extent forfeiture rates are different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. Interest and Other Income, Net Interest and other income, net, increased $119 million from the three months ended September 30, 2013 to the three months ended September 30, 2014. This increase was primarily driven by a decrease in foreign currency exchange losses of $92 million related to the change in time value of our foreign currency options and an increase in realized gains on available-for-sale investments of $44 million. Interest and other income, net, increased $251 million from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. This increase was primarily driven by realized gains on non-marketable equity investments of $139 million and previously-held equity interests of $126 million, partially offset by a decrease in interest income of $34 million. The costs of our foreign exchange hedging activities that we recognized to interest and other income, net, are primarily a function of the notional amount of the option and forward contracts and their related duration, the movement of the foreign exchange rates relative to the strike prices of the contracts, as well as the volatility of the foreign exchange rates. As we expand our international business, we believe costs related to hedging activities under our foreign exchange risk management program may increase in dollar amount in the remainder of 2014 and future periods. 38-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes The following table presents our provision for income taxes and the effective tax rate for the periods presented (dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2013 2014 2013 2014 (unaudited) Provision for income taxes $ 612 $ 859 $ 1,893 $ 2,594 Effective tax rate 16.2 % 22.3 % 16.7 % 20.4 % Our provision for income taxes and effective tax rate increased from the three months ended September 30, 2013 to the three months ended September 30, 2014, primarily due to changes in estimates associated with filed tax returns in both periods, an impairment charge not deductible for tax purposes and unfavorable impact of proportionally more earnings in higher tax rate jurisdictions. Our provision for income taxes and effective tax rate increased from the nine months ended September 30, 2013 to the nine months ended September 30, 2014, largely attributed to the expiration of the federal research and development credit as of December 31, 2013. Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service (IRS) and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. See Critical Accounting Policies and Estimates below for additional information about our provision for income taxes. Net Income (Loss) from Discontinued Operations Motorola Mobile On January 29, 2014, we entered into an agreement with Lenovo providing for the disposition of the Motorola Mobile business for a total purchase price of approximately $2.9 billion (subject to certain adjustments), including $1.4 billion to be paid at close, comprised of $660 million in cash and $750 million in Lenovo ordinary shares (subject to a share cap and floor). The remaining $1.5 billion will be paid in the form of an interest-free, three-year prepayable promissory note. We will maintain ownership of the vast majority of the Motorola Mobile patent portfolio, including current patent applications and invention disclosures, which will be licensed back to Motorola Mobile for its continued operations. Additionally, in connection with the sale, we will indemnify Lenovo for certain potential liabilities of the Motorola Mobile business. The transaction is subject to the satisfaction of regulatory requirements, customary closing conditions and any other needed approvals and is expected to close in the fourth quarter of 2014. As such, financial results of Motorola Mobile are presented as "Net income (loss) from discontinued operations" on the Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2014; and assets and liabilities of Motorola Mobile to be disposed of are presented as "Assets held for sale" and "Liabilities held for sale" on the Consolidated Balance Sheet as of September 30, 2014, respectively. The following table presents financial results of the Motorola Mobile business included in "Net income (loss) from discontinued operations" for the three and nine months ended September 30, 2013 and 2014 (in millions, unaudited): 39-------------------------------------------------------------------------------- Table of Contents Three Months Ended September 30, Nine Months Ended September 30, 2013 2014 2013 2014 Revenues $ 1,139 $ 1,718 $ 3,155 $ 4,901 Loss from discontinued operations before income taxes (307 ) (217 ) (909 ) (590 ) Benefits from income taxes 99 32 277 139 Net loss from discontinued operations $ (208 ) $ (185 ) $ (632 ) $ (451 ) Motorola Home In December 2012, we entered into an agreement with Arris and certain other persons providing for the disposition of the Motorola Home business. The transaction closed on April 17, 2013 (the date of divestiture). Financial results of Motorola Home through the date of divestiture were included in "Net income (loss) from discontinued operations" for the three and nine months ended September 30, 2013. The following table presents financial results of the Motorola Home business included in "Net income (loss) from discontinued operations" for the three and nine months ended September 30, 2013 (in millions, unaudited): Three Months Ended September Nine Months Ended 30, September 30, 2013 2013 (1) Revenues $ 0 $ 804 Loss from discontinued operations before income taxes 0 (67 ) Benefits from income taxes 0 16 Gain on disposal 15 $ 762 Net income from discontinued operations $ 15 $ 711 (1) The operating results of Motorola Home were included in our Consolidated Statements of Income from January 1, 2013 through the date of divestiture. Liquidity and Capital Resources As of September 30, 2014, we had $62.3 billion of cash, cash equivalents, and marketable securities which includes $160 million of cash and cash equivalents classified as "Assets held for sale". Cash equivalents and marketable securities are comprised of time deposits, money market and other funds, including cash collateral received related to our securities lending program, fixed-income bond funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate securities, mortgage-backed securities, asset-backed securities, and marketable equity securities. As of September 30, 2014, $41.8 billion of the $62.3 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. As of September 30, 2014, we had unused letters of credit of approximately $949 million. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Our liquidity could be negatively affected by a decrease in demand for our products and services. In addition, we may make acquisitions or license products and technologies complementary to our business and may need to raise additional capital through future debt or equity financing to provide for greater flexibility to fund any such acquisitions and licensing activities. Additional financing may not be available at all or on terms favorable to us. 40-------------------------------------------------------------------------------- Table of Contents We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of September 30, 2014, we had $2.0 billion of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.1% that mature at various dates through March 2015. Average commercial paper borrowings during the quarter were $2.0 billion and the maximum amount outstanding during the quarter was $2.0 billion. In conjunction with this program, we have a $3.0 billion revolving credit facility expiring in July 2016. The interest rate for the credit facility is determined based on a formula using certain market rates. As of September 30, 2014, we were in compliance with the financial covenant in the credit facility and no amounts were outstanding. In May 2011, we issued $3.0 billion of unsecured senior notes (2011 Notes) in three equal tranches, due in 2014, 2016, and 2021. In February 2014, we issued $1.0 billion of unsecured senior notes (2014 Notes) due in 2024. The net proceeds from the sale of the 2011 Notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. On May 19, 2014, we repaid $1.0 billion on the first tranche of our 2011 Notes upon maturity. We used the net proceeds from the issuance of the 2014 Notes to repay this tranche and for general corporate purposes. As of September 30, 2014, the total carrying value and estimated fair value of the 2011 and 2014 notes were $3.0 billion and $3.1 billion, respectively. The fair value was determined based on observable market prices of identical instruments in less active markets. We are not subject to any financial covenants under the notes. In August 2013, we entered into a $258 million capital lease obligation on certain property expiring in 2028 with an option to purchase in 2016. The effective rate of the capital lease obligation approximates the market rate. The estimated fair value of the capital lease obligation approximated its carrying value as of September 30, 2014. For the nine months ended September 30, 2013 and 2014, our cash flows were as follows (in millions): Nine Months Ended September 30, 2013 2014 (unaudited)Net cash provided by operating activities $ 13,421 $ 16,012 Net cash used in investing activities (12,062 ) (17,814 ) Net cash used in financing activities (889 ) (1,095 ) Cash Provided by Operating Activities Our largest source of cash provided by operating cash flows is advertising revenues generated by Google websites and Google Network Members' websites. We also generate cash from sales of our hardware products, primarily in the Motorola Mobile business, and revenues from digital content and licensing. Our primary uses of cash from operating activities include payments to our Google Network Members and distribution partners, which are based on the revenue share or fixed fee arrangements, payments for manufacturing and inventory-related costs primarily for the Motorola Mobile business, as well as content acquisition costs. In addition, uses of cash from operating activities include compensation and related costs, other general corporate expenditures, and income taxes. Cash provided by operating activities is calculated by adjusting net income to exclude non-cash items, including stock-based compensation expense, depreciation, amortization, deferred income taxes, excess tax benefits from stock-based award activities, as well as the effect of changes in working capital and other activities. Net cash provided by operating activities increased from the nine months ended September 30, 2013 to the nine months ended September 30, 2014, primarily due to increased net income adjusted for depreciation expense and loss on disposal of property and equipment, gain on divestiture of business, and stock-based compensation expense, offset by deferred income taxes, excess tax benefit from stock-based award activities, and gains on equity interest and sales of non-marketable securities. In addition, there was a net increase in cash from changes in working capital from the nine months ended September 30, 2013 to the nine months ended September 30, 2014 primarily due to the impact from changes in prepaid revenue share, expenses and other assets, income taxes, net and accrued expenses and other liabilities, offset by the impact from changes in accounts payable. As we expand our business internationally, we have offered payment terms to certain advertisers that are standard in their locales but longer than terms we would generally offer to our domestic advertisers. This may increase our working capital requirements and may have a negative effect on cash provided by our operating activities. 41-------------------------------------------------------------------------------- Table of Contents Cash Used In Investing Activities Cash provided by or used in investing activities primarily consist of purchases, maturities, and sales of marketable securities, acquisitions of businesses and intangible assets, divestiture of businesses, and purchases of property and equipment. In addition, cash provided by or used in investing activities include our investments in reverse repurchase agreements and the cash collateral received or returned from our securities lending program. Cash used in investing activities increased from the nine months ended September 30, 2013 to the nine months ended September 30, 2014, primarily attributable to an increase in spend related to acquisitions and a decrease in proceeds received related to divestiture of businesses. In addition, there was an increase in capital expenditures made primarily related to data centers, real estate, and production equipment. This activity was offset by a net decrease in marketable securities activity and increased cash receipts from cash collateral received from securities lending. In order to manage expected increases in internet traffic, advertising transactions, and new products and services, and to support our overall global business expansion, we expect to make significant investments in production equipment, our systems, data centers, corporate facilities, and information technology infrastructure in 2014 and thereafter. However, the amount of our capital expenditures has fluctuated and may continue to fluctuate on a quarterly basis. In addition, we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our expertise in engineering and other functional areas, our technologies, and our product and service offerings. Cash Used In Financing Activities Cash used in financing activities consists primarily of net proceeds or payments from issuance or repayments of debt and net proceeds or payments and excess tax benefits from stock-based award activities. Cash used in financing activities increased modestly from the nine months ended September 30, 2013 to the nine months ended September 30, 2014, primarily driven by an increase in net payments for stock-based award activities offset by a decrease in net repayments of debt. Contractual Obligations We had long-term taxes payable of $3.1 billion as of September 30, 2014 primarily related to tax positions for which the timing of the ultimate resolution is uncertain. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income 42-------------------------------------------------------------------------------- Table of Contents taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. Our effective tax rates have differed from the statutory rate primarily due to the tax impact of foreign operations, state taxes, certain benefits realized related to stock-based award activities, and research and development tax credits. The effective tax rates were 16.2% and 22.3% for the three months ended September 30, 2013 and 2014 and 16.7% and 20.4% for the nine months ended September 30, 2013 and 2014, respectively. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, indirect taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred, and the amount can be reasonably estimated. If we determine that a loss is possible and a range of the loss can be reasonably estimated, we disclose the range of the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related ranges of possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 10 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information regarding contingencies. Business Combinations We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include but are not limited to future expected cash flows from customer relationships and acquired patents and developed technology, and discount rates. Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed, as more fully discussed in Note 5 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Goodwill Goodwill is allocated to reporting units expected to benefit from the business combination. We test goodwill for impairment at the reporting unit level at least annually, or more frequently if events or changes in circumstances occur that would more likely than not reduce the fair value of a reporting unit below its carrying value. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill impairment tests require judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. As of September 30, 2014, no impairment of goodwill has been identified. 43-------------------------------------------------------------------------------- Table of Contents Impairment of Marketable and Non-Marketable Securities We periodically review our marketable and non-marketable securities for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as interest and other income, net. Available Information Our website is located at www.google.com, and our investor relations website is located at http://investor.google.com. The following filings are available through our investor relations website after we file them with the SEC: Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements for our annual meetings of stockholders, for the last three years, and are also available for download free of charge. We also provide a link to the section of the SEC's website at www.sec.gov that has all of our public filings, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports, our Proxy Statements, and other ownership related filings. Further, a copy of this Quarterly Report on Form 10-Q is located at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. We webcast our earnings calls and certain events we participate in or host with members of the investment community on our investor relations website. Additionally, we provide notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases, and blogs as part of our investor relations website as well as on our investor relations Google+ page (https://plus.google.com/+GoogleInvestorRelations/posts). Investors and others can receive notifications of new information posted on our investor relations website in real time by signing up for email alerts and RSS feeds. Further corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Corporate Governance." The content of our websites are not incorporated by reference into this Quarterly Report on Form 10-Q or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. 44-------------------------------------------------------------------------------- Table of Contents |