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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. 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. Our mission is to organize the world's information and make it universally accessible and useful. We serve three primary constituencies: • Users. We provide users with products and services that enable people to more quickly and easily find, create, and organize information that is useful to them. • Advertisers. We provide advertisers with cost-effective ways to deliver online and offline ads to customers across Google-owned websites and through the Google Network, which is the network of third parties that use our advertising programs to deliver relevant ads with their search results and content. • Google Network Members and Other Content Providers. We provide members of our Google Network with our Google AdSense programs. These include programs through which we distribute our advertisers' AdWords ads for display on the websites of our Google Network Members. We share most of the fees these ads generate with our Google Network Members, thereby creating an important revenue stream for them. In addition, we have entered into arrangements with other content providers under which we distribute or license their video and other content, and we may display ads next to or as part of this content on the pages of our websites. We share most of the fees these ads generate with these content providers, thereby creating an important revenue stream for these partners. Recent Development In April 2012, our Board of Directors approved amendments to our certificate of incorporation that would, among other things, create Class C capital stock. The amendments are reflected in our New Charter, the adoption of which is subject to the approval of stockholders at our 2012 Annual Meeting of Stockholders to be held on June 21, 2012. Assuming the adoption of the New Charter is approved, the Board of Directors has also stated its intention to distribute shares of the Class C capital stock as a stock dividend, whereby the holders of Class A and Class B common stock outstanding, as of a record date to be determined by the Board of Directors, will be entitled to receive one share of Class C capital stock for every share they hold. The Class C capital stock will have no voting rights, except as required by applicable law. Except as expressly provided in the New Charter, shares of Class C capital stock will have the same rights and privileges and rank equally, share ratably and be identical in all other respects to the shares of Class A and Class B common stock as to all matters. How We Generate Revenue Advertising revenues made up 97% and 96% of our revenues in the first quarter of 2011 and 2012. We derive most of our other revenues from our enterprise products, as well as our display advertising management services to advertisers, ad agencies, and publishers. Google AdWords is our auction-based advertising program that enables advertisers to place text-based and display ads on our websites and our Google Network Members' websites. Display advertising comprises the videos, text, images, and other interactive ads that run across the web on computers and mobile devices, including smart phones and handheld computers such as netbooks and tablets. Most of our AdWords advertisers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user clicks on one of its ads. We also offer AdWords on a cost-per-impression basis that enables advertisers to pay us based on the number of times their ads appear on our websites and our Google Network Members' websites as specified by the advertisers. For advertisers using our AdWords cost-per-click pricing, we recognize as revenue the fees charged to advertisers each time a user clicks on one of the ads that appears next to the search results or content on our websites or our Google Network Members' websites. For advertisers using our AdWords cost-per-impression pricing, we recognize as revenue the fees charged to advertisers each time their ads are displayed on our websites or our Google Network Members' websites. Our AdWords agreements are generally terminable at any time by our advertisers. 27 -------------------------------------------------------------------------------- Table of Contents Google AdSense refers to the online programs through which we distribute our advertisers' AdWords ads for display on our Google Network Members' websites, as well as programs to deliver ads on television broadcasts. Our AdSense programs include AdSense for search and AdSense for content. 28 -------------------------------------------------------------------------------- Table of Contents AdSense for search is our online service for distributing relevant ads from our advertisers for display with search results on our Google Network Members' websites. To use AdSense for search, most of our AdSense for search partners add Google search functionality to their web pages in the form of customizable Google search boxes. When visitors to these websites search either the website or the internet using these customizable search boxes, we display relevant ads on the search results pages, targeted to match user search queries. Ads shown through AdSense for search are text ads. AdSense for content is our online service for distributing ads from our advertisers that are relevant to content on our Google Network Members' websites. Under this program, we use automated technology to analyze the meaning of the content on the web page and serve relevant ads based on the meaning of such content. For example, a web page on an automotive blog that contains an entry about vintage cars might display ads for vintage car parts or vintage car shows. These ads are displayed in spaces that our AdSense for content partners have set aside on their websites. AdSense for content allows a variety of ad types to be shown, including text ads, image ads, Google Video Ads, link units (which are sets of clickable links to topic pages related to page content), themed units (which are regular text ads with graphic treatments that change seasonally and by geography), and gadget ads (which are customized "mini-sites" that run as ads on AdSense publisher websites). For our online AdSense program, our advertisers pay us a fee each time a user clicks on one of our advertisers' ads displayed on our Google Network Members' websites or, for those advertisers who choose our cost-per-impression pricing, as their ads are displayed. To date, we have paid most of these advertiser fees to our Google Network Members, and we expect to continue doing so for the foreseeable future. We recognize these advertiser fees as revenue and the portion of the advertiser fee we pay to our Google Network Members as traffic acquisition costs under cost of revenues. Google Network Members do not pay any fees associated with the use of our AdSense program on their websites. Our agreements with Google Network Members consist largely of uniform online "click-wrap" agreements that members enter into by interacting with our registration websites. The standard agreements have no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to share with the Google Network Member most of the advertiser fees generated by users clicking on ads on the Google Network Member's website or, for advertisers who choose our cost-per-impression pricing, as the ads are displayed on the Google Network Member's website. For example, under our standard agreements, we pay 51% and 68% of the fees collected from advertisers to our Google Network Members in AdSense for search and AdSense for content, respectively. We also offer display advertising management services such as media planning, buying, implementation, and measurement tools for advertisers and agencies, and forecasting and reporting tools for publishers. We recognize the related fees as other revenues in the period advertising impressions are delivered. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. Our agreements with content providers are typically standard agreements with no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to pay the content providers for the content we license. 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 recognize these advertiser fees as revenue and the fees we pay to our content providers as content acquisition costs under cost of revenues. We believe the factors that influence the success of our advertising programs include the following: • The relevance, objectivity, and quality of our search results and the relevance and quality of ads displayed with each search results page. • The number of searches initiated at our websites and our Google Network Members' websites and the underlying purpose of these searches (for instance, whether they are for academic research, to find a news article, or to find a product or service). • The number and prominence of ads displayed on our websites and our Google Network Members' websites. • The number of visits to, and the content of, our Google Network Members' websites and certain of our websites and the relevance and quality of the ads we display next to this content. • The advertisers' return on investment from advertising campaigns on our websites or our Google Network Members' websites compared to other forms of advertising. • The total advertising spending budgets of each advertiser. • The number of advertisers and the breadth of items advertised. 29 -------------------------------------------------------------------------------- Table of Contents • The amount we ultimately pay our Google Network Members, distribution partners, and our content providers for traffic, access points, and content, compared to the amount of revenues we generate. • Our ability to increase traffic on our websites and our Google Network Members' websites via new and improved ad formats, through devices other than personal computers, such as mobile devices and tablets. Trends in Our Business 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, query growth rates and how consumers make queries, challenges in maintaining our growth rate as our revenues increase to higher levels, and increasing maturity of the online advertising market and other markets in which we participate. Mobile devices are also now significant gateways to information. We expect that our revenue growth rate will also be affected by evolving consumer preferences in this market, as well as advertising trends and the acceptance by mobile users of our products and services. In addition, if there is a further general economic downturn, this may result in fewer commercial queries by our users and may cause advertisers to reduce the amount they spend on online advertising, including the amount they are willing to pay for each click or impression, which could negatively affect the growth rate of our revenues. We plan to continue to invest aggressively in our core areas of strategic focus. The main focus of our advertising programs is to provide relevant and useful advertising to our users, 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 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 continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenues, as well as aggregate paid click 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. We also continue to invest aggressively in our systems, data centers, corporate facilities, information technology infrastructure, and employees. We expect to increase our hiring in 2012 and provide competitive compensation programs for our employees. Our full-time employee headcount was 26,316 at March 31, 2011 and 33,077 at March 31, 2012. Acquisitions will also remain an important component of our strategy and use of capital, and we expect our current pace of acquisitions to continue. 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, 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. 30 -------------------------------------------------------------------------------- Table of Contents 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. Results of Operations The following table presents our historical operating results as a percentage of our revenues for the periods indicated: Three Months Ended March 31, 2011 2012 (unaudited) Consolidated Statements of Income Data: Revenues 100.0 % 100.0 % Costs and expenses: Cost of revenues 34.2 35.6 Research and development 14.3 13.5 Sales and marketing 12.0 11.9 General and administrative 6.9 7.2 Charge related to resolution of Department of Justice investigation 5.8 0 Total costs and expenses 73.2 68.2 Income from operations 26.8 31.8 Interest and other income, net 1.1 1.5 Income before income taxes 27.9 33.3 Provision for income taxes 6.9 6.2 Net income 21.0 % 27.1 % Revenues The following table presents our revenues, by revenue source, for the periods presented (in millions): Three Months Ended March 31, 2011 2012 (unaudited) Advertising revenues: Google websites $ 5,879 $ 7,312 Google Network Members' websites 2,427 2,913 Total advertising revenues 8,306 10,225 Other revenues 269 420 Revenues $ 8,575 $ 10,645 31 -------------------------------------------------------------------------------- Table of Contents The following table presents our revenues, by revenue source, as a percentage of total revenues for the periods presented: Three Months Ended March 31, 2011 2012 (unaudited) Advertising revenues: Google websites 69 % 69 % Google Network Members' websites 28 27 Total advertising revenues 97 96 Google websites as % of advertising revenues 71 72 Google Network Members' websites as % of advertising revenues 29 28 Other revenues 3 % 4 % The increase in our revenues from the three months ended March 31, 2011 to the three months ended March 31, 2012 resulted primarily from an increase in advertising revenues generated by Google websites and 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 paid clicks through our advertising programs, partially offset by a decrease in the average cost-per-click paid by our advertisers. The increase in the number of paid clicks generated through our advertising programs was due to an increase in aggregate traffic, certain monetization improvements including new ad formats, the continued global expansion of our products, advertisers, and user base, as well as an increase in the number of Google Network Members. The decrease in the average cost-per-click paid by our advertisers was driven by various factors, such as the general strengthening of the U.S dollar compared to certain foreign currencies (primarily the Euro), the changes in platform mix due to traffic growth in mobile devices, where the average cost-per-click is typically lower compared to desktop computers and tablets, and the changes in geographical mix due to traffic growth in emerging markets, where the average cost-per-click is typically lower compared to more mature markets. Improvements in our ability to ultimately 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 increasing site links to be full size links with the URL (uniform resource locator), moving a portion of the first line of the ad to the heading to better promote the content of the ad, providing an option to preview the ad, and moving the ad's URL to a separate line below the heading for greater page format consistency. 32 -------------------------------------------------------------------------------- Table of Contents Aggregate paid clicks on Google websites and Google Network Members' websites increased approximately 39% from the three months ended March 31, 2011 to the three months ended March 31, 2012. Average cost-per-click on Google websites and Google Network Members' websites decreased approximately 12% from the three months ended March 31, 2011 to the three months ended March 31, 2012. The rate of change in aggregate paid clicks and average cost-per-click, 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, including mobile devices, also contributes to these fluctuations. Changes in aggregate paid clicks and average cost-per-click may not be indicative of our performance or advertiser experiences in any specific geographic market, vertical, or industry. 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, and Google Network Members and other partners. Revenues by Geography The following table presents our domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers: Three Months Ended March 31, 2011 2012 (unaudited) United States 47 % 46 % United Kingdom 11 % 11 % Rest of the world 42 % 43 % The growth in international revenues (other than the United Kingdom) as a percentage of consolidated revenues from the three months ended March 31, 2011 to the three months ended March 31, 2012 resulted largely from increased acceptance of our advertising programs, our continued progress in developing localized versions of our products for these international markets, partially offset by a general strengthening of the U.S dollar compared to certain foreign currencies (primarily the Euro). The general strengthening of the U.S. dollar relative to certain foreign currencies (primarily the Euro) from the three months ended March 31, 2011 to the three months ended March 31, 2012 had an unfavorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $7 million, or 0.6%, higher and our revenues from the rest of the world would have been approximately $60 million, or 1.3%, higher in the three months ended March 31, 2012. This is before consideration of hedging gains of $4 million and $33 million recognized to revenues from the United Kingdom and the rest of the world in the three months ended March 31, 2012. 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 2012 or thereafter. See Note 15 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. Costs and Expenses Cost of Revenues Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts ultimately 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. 33 -------------------------------------------------------------------------------- Table of Contents 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 (approximately two years) to the extent we can reasonably estimate those lives and they are longer than one year, 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, credit card and other transaction fees related to processing customer transactions including Google Checkout transactions, amortization of acquired intangible assets, as well as 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. 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 on a straight-line basis, whichever is greater, over the terms 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 March 31, 2011 2012 (unaudited) Cost of revenues $ 2,936 $ 3,789 Cost of revenues as a percentage of revenues 34.2 % 35.6 % Three Months Ended March 31, 2011 2012 (unaudited) Traffic acquisition costs related to AdSense arrangements $ 1,701 $ 2,042 Traffic acquisition costs related to distribution arrangements 337 468 Traffic acquisition costs $ 2,038 $ 2,510 Traffic acquisition costs as a percentage of advertising revenues 24.5 % 24.5 % Cost of revenues increased $853 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. The increase was primarily related to an increase in traffic acquisition costs of $341 million resulting from more advertiser fees generated through our AdSense program. The increase was also related to an increase in traffic acquisition costs of $131 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. In addition, there was an increase in data center costs of $247 million primarily resulting from the depreciation of additional information technology assets and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $82 million primarily related to content displayed on YouTube. We expect cost of revenues will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2012 and in future periods, primarily as a result of forecasted increases in traffic acquisition costs, data center costs, credit card and other transaction fees, content acquisition costs, 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. 34 -------------------------------------------------------------------------------- Table of Contents • 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 March 31, 2011 2012 (unaudited) Research and development expenses $ 1,226 $ 1,441 Research and development expenses as a percentage of revenues 14.3 % 13.5 % Research and development expenses consist primarily of compensation and related costs for personnel responsible for the research and development of new and existing products and services. We expense research and development costs as incurred. Research and development expenses increased $215 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This increase was primarily due to an increase in labor and facilities-related costs of $96 million, largely as a result of a 20% increase in research and development headcount, including headcount from acquisitions. In addition, there was an increase in stock-based compensation expense of $62 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 2012 and in future periods because we expect to continue to invest in building necessary employee and systems infrastructures required to support the development of new, and improve existing, products and services. 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 March 31, 2011 2012 (unaudited) Sales and marketing expenses $ 1,026 $ 1,269 Sales and marketing expenses as a percentage of revenues 12.0 % 11.9 % 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 $243 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This increase was primarily due to an increase in labor and facilities-related costs of $115 million, largely as a result of a 27% increase in sales and marketing headcount, including headcount from acquisitions, as well as an increase in advertising and promotional expenses of $78 million. In addition, there was an increase in stock-based compensation expense of $19 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 2012 and in 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. 35 -------------------------------------------------------------------------------- Table of Contents 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 March 31, 2011 2012 (unaudited) General and administrative expenses $ 591 $ 757 General and administrative expenses as a percentage of revenues 6.9 % 7.2 % 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, and fees for professional services. Professional services are principally comprised of outside legal, audit, information technology consulting, and outsourcing services. General and administrative expenses increased $166 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This increase was primarily due to an increase in labor and facilities-related costs of $61 million, primarily as a result of a 30% increase in general and administrative headcount, including headcount from acquisitions, as well as an increase in fees for professional services of $42 million, the majority of which was related to legal costs. In addition, there was an increase in stock-based compensation expense of $18 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 2012 and in future periods. 36 -------------------------------------------------------------------------------- Table of Contents Charge Related to the Resolution of Department of Justice Investigation In connection with a resolution of an investigation by the United States Department of Justice into the use of Google advertising by certain advertisers, we accrued $500 million during the three months ended March 31, 2011, which was paid in August 2011 upon final resolution of that matter. Stock-Based Compensation The following table presents our stock-based compensation, and stock-based compensation as a percentage of revenues, for the periods presented (dollars in millions): Three Months Ended March 31, 2011 2012 (unaudited) Stock-based compensation $ 432 $ 556 Stock-based compensation as a percentage of revenues 5.0 % 5.2 % Stock-based compensation increased $124 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This increase was primarily due to additional stock awards issued to existing and new employees. We estimate stock-based compensation to be approximately $2 billion in 2012 and $2.6 billion thereafter. This estimate does not include expenses to be recognized related to employee stock awards that are granted after March 31, 2012 or non-employee stock awards that have been or may be granted. 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 $60 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This increase was primarily driven by an increase in realized gains on investments of $93 million, partially offset by an increase in interest expense of $16 million and an increase in net foreign exchange related costs of $15 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, and 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 2012 and in future periods. Provision for Income Taxes The following table presents our provision for income taxes, and effective tax rate for the periods presented (dollars in millions): Three Months Ended March 31, 2011 2012 (unaudited) Provision for income taxes $ 594 $ 655 Effective tax rate 24.8 % 18.5 % 37 -------------------------------------------------------------------------------- Table of Contents Our provision for income taxes increased from the three months ended March 31, 2011 to the three months ended March 31, 2012, primarily as a result of increases in federal income taxes, driven by higher taxable income year over year. Our effective tax rate decreased from the three months ended March 31, 2011 to the three months ended March 31, 2012, primarily as a result of a discrete item recognized related to an investigation by the Department of Justice in the three months ended March 31, 2011 and proportionately more earnings expected to be realized in countries where we have lower statutory tax rates. 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 where we have lower statutory rates and higher than anticipated in countries where we 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 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. Liquidity and Capital Resources In summary, our cash flows were as follows (in millions): Three Months Ended March 31, 2011 2012 (unaudited) Net cash provided by operating activities $ 3,172 $ 3,694 Net cash provided by (used in) investing activities (4,421 ) 8,151 Net cash provided by (used in) financing activities (111 ) 1,230 At March 31, 2012, we had $49.3 billion of cash, cash equivalents, and marketable securities. 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, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments and municipalities in the U.S., corporate securities, and mortgage-backed securities. As of March 31, 2012, $25.7 billion of the $49.3 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. At March 31, 2012, we had unused letters of credit for approximately $44 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. We have established a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from the commercial paper program are used for general corporate purposes. As of March 31, 2012, we had $2.0 billion of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.1% that matures at various dates through August 2012. Average commercial paper borrowings during the three months ended March 31, 2012 were $1.2 billion, and the maximum amount of commercial paper borrowings outstanding during the three months ended March 31, 2012 was $2.0 billion. In conjunction with this program, we established a $3.0 billion revolving credit facility expiring in July 2016. Interest rate for the credit facility is determined based on a formula using certain market rates. As of March 31, 2012, we were in compliance with the financial covenants in these credit facilities and no amounts were outstanding. Additionally, as of March 31, 2012, we had a $468 million secured promissory note outstanding recorded as short-term debt, with an interest rate of 1.0% that matures in December 2012. 38 -------------------------------------------------------------------------------- Table of Contents In May 2011, we issued $3.0 billion of unsecured senior notes in three equal tranches, due in 2014, 2016, and 2021, with stated interest rates of 1.25%, 2.125%, and 3.625%. The net proceeds from the sale of the notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. As of March 31, 2012, the total carrying value and estimated fair value of these notes were $3.0 billion and $3.1 billion. The estimated fair value was based on quoted prices for our publicly-traded debt as of March 30, 2012. We are not subject to any financial covenants under the notes. In August 2011, we entered into an Agreement and Plan of Merger with Motorola, a provider of innovative technologies, products and services that enable a range of mobile and wireline digital communication, information and entertainment experiences, under which we will acquire Motorola for $40 per share in cash, or a total of approximately $12.5 billion. The completion of this transaction is subject to customary closing conditions, including the receipt of certain regulatory approvals. In the event the Merger Agreement is terminated due to a failure to obtain certain regulatory approvals, we would be required to pay Motorola a fee of $2.5 billion. The transaction is currently expected to close in the first half of 2012. Cash provided by operating activities consist of net income adjusted for certain non-cash items, including amortization, depreciation, deferred income taxes, excess tax benefits from stock-based award activities, and stock-based compensation expense, as well as the effect of changes in working capital and other activities. Cash provided by operating activities in the three months ended March 31, 2012 was $3,694 million and consisted of net income of $2,890 million, adjustments for non-cash items of $1,325 million and cash used in working capital and other activities of $521 million. Adjustments for non-cash items primarily consisted of $556 million of stock-based compensation expense, $378 million of depreciation and amortization expense on property and equipment, $354 million of deferred income taxes, and $133 million of amortization of intangible and other assets. In addition, the decrease in cash from changes in working capital activities primarily consisted of a decrease in accrued expenses of $855 million primarily as a result of employee bonuses accrued for the year ended December 31, 2011, and paid in the first quarter of 2012, as well as an increase in prepaid revenue share, expenses, and other assets of $308 million. These decreases were offset by a decrease in accounts receivable of $301 million due to the timing of collections, an increase in accounts payable of $169 million, and a net increase in incomes taxes payable and deferred income taxes of $143 million. Cash provided by operating activities in the three months ended March 31, 2011 was $3,172 million and consisted of net income of $1,798 million, adjustments for non-cash items of $1,134 million and cash provided by working capital and other activities of $240 million. Adjustments for non-cash items primarily consisted of $432 million of stock-based compensation expense, $301 million of depreciation and amortization expense on property and equipment, $289 million of deferred income taxes, and $100 million of amortization of intangible and other assets. In addition, the increase in cash from changes in working capital activities primarily consisted of a decrease in accounts receivable of $181 million due to the timing of collections and a net increase in incomes taxes payable and deferred income taxes of $73 million. These increases were partially offset by an increase in prepaid revenue share, expenses and other assets of $78 million. 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. Cash provided by investing activities in the three months ended March 31, 2012 of $8,151 million was primarily attributable to net maturities and sales of marketable securities of $8,513 million, as well as cash collateral received and maturities of reverse repurchase agreements of $440 million in connection with our securities lending program. These increases were partially offset by capital expenditures of $607 million related principally to our facilities, data centers, and related equipment. Cash used in investing activities in the three months ended March 31, 2011 of $4,421 million was primarily attributable to net purchases of marketable securities of $2,946 million, capital expenditures of $890 million related principally to our facilities, data centers and related equipment, and cash consideration used in acquisitions and other investments of $279 million. Also, in connection with our securities lending program, we returned $481 million of cash collateral and received $175 million from maturities of certain reverse repurchase agreements. 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 our systems, data centers, corporate facilities, and information technology infrastructure in 2012 and thereafter. However, the amount of our capital expenditures has fluctuated and may continue to fluctuate on a quarterly basis. 39 -------------------------------------------------------------------------------- Table of Contents In addition, we expect to spend a significant amount of cash on acquisitions and other investments from time to time. These acquisitions generally enhance the breadth and depth of our expertise in engineering and other functional areas, our technologies, and our product offerings. Cash provided by financing activities in the three months ended March 31, 2012 of $1,230 million was primarily driven by net proceeds of $1,249 million from short-term debt issued under our commercial paper program. This was partially offset by net payments for stock-based award activities of $47 million. Cash used in financing activities in the three months ended March 31, 2011 of $111 million was primarily driven by net payment of $251 million of short-term debt issued under our commercial paper program. This was partially offset by net proceeds from stock-based award activities of $116 million. Contractual Obligations We recorded long-term taxes payable of $96 million in the three months ended March 31, 2012 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 accounting principles generally accepted in the U.S. (U.S. 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 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. 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 award activities, and research and experimentation tax credits. The effective tax rates were 24.8% and 18.5% for the three months ended March 31, 2011 and 2012. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we 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. We regularly assess the likelihood of adverse outcomes resulting from these examinations 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, tax, labor and employment 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. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and 40 -------------------------------------------------------------------------------- Table of Contents make adjustments 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 12 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. Stock-Based Compensation Our stock-based compensation expense is estimated at the grant date based on the award's fair value as calculated by the Black-Scholes-Merton (BSM) option pricing model and is recognized as expense over the requisite service period. The BSM model requires various highly judgmental assumptions including expected volatility and expected term. If any of the assumptions used in the BSM model changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience and our expectations regarding future pre-vesting termination behavior of employees. To the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly. 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. These filings are also available for download free of charge on our investor relations website. 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. 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 contents of our websites are not intended to be 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. |