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North America Equity Research J.P. Morgan 19 July 2013 Overweight Google GOOG, GOOG US Price: $910.68 Would Be Buying the Weakness; Remain Positive on V Price Target: $1,015.00 Shift to Mobile and Enhanced Campaigns; $1,015 PT Previous: $1,025.00 We remain positive on Google shares coming out of 2Q earnings and we'd be buying Internet the after-market weakness. Light revenue was largely attributable to self-inflicted Doug Anmuth AC policy changes impacting the Google Network and we're comfortable with the magnitude of increased investment spending given Google's track record on innovation and many large growth opportunities ahead. We continue to believe that Bloomberg JPMA ANMUTH <GO, mobile and display, Enhanced Campaigns, and Google Shopping/PLAs should drive Bo Nam stronger Y/Y growth in 2H13 and into 2014. We reiterate our Overweight rating and $1,015 price target. Kaizad Gotla. CFA • 2Q results modestly below expectations. Google Inc. consolidated gross revenue of $14.18 (+19% Y/Y, +1% Q/Q) was 2.7% below our estimate of $14.58 due to softness in the Google Network (4.6% light) and Motorola (13.2% light). Lower Diana R Kluger revenue and increased investments led to non-GAAP operating income of $3.998 and non-GAAP EPS of $9.56, 8% and 12% below our expectations. Higher expenses were evident in Sales & Marketing and G&A as Google Segment J.P. Morgan Secunties !SC headcount grew 4% Q/Q and the company invested more in marketing. An accounting change related to depreciation also contributed —$60M of 1-time Price Performance expenses. reo • Google Sites and Google Network dynamics similar to IQ. Google Segment net S750 - revenue of $10.1B came in 1.6% below our S10.3B estimate as the Google Network ao was again impacted by ad policy changes, along with higher TAC. Google's ad %4 policy changes should drive a better experience for users and advertisers over time, JIM Cel42 lama 403. APO and we remain encouraged by 16% growth in Google Sites net revenue. - 4000 seers Moe ($1 SISP$00 (rebned) • Motorola priming for Moto X launch. Motorola results were light on both the top TM In 3m 12m Abe 25.9% 1.1% 19.9% 562% and bottom lines as smartphone share remains low and the feature phone business Pei 10.4% -12% 9.3% 33.1% winds down, but the focus is clearly on the Moto X coming this fall. Ahead of the launch and presumably a large supporting marketing campaign already underway, Motorola reduced its headcount by —50% Q/Q, excluding the Home business. • Price target goes to $1,015. We are adjusting our estimates and now look for 2013 and 2014 Google Inc. gross revenue of $59.6B and $70.28 along with non-GAAP EPS of $43.66 and S52.18. Our revenue changes are negligible, but our EPS comes down 6% for 2013 and 4% for 2014. Our S1,015 price target is based on —16x 2015E non-GAAP EPS of$62.14. Google Inc (GOOG;GOOG US) FYE Dec 2012A 2013E 2013E 2014E 2014E 2015E 2015E Company Data (Prey) /Curd (Pnev) (Cuff) (Prey) (Curt) Plies ($) 910.68 EPS - Reported ($) Date Of Price 18 Jul 13 01 (Mar) 10.08 11.58A 11.58A 52-week Range (5) 928.00-576.13 02 (Jun) 10.12 10.92 9.56A Market Cap (S mn) 303,542.40 03 (Sep) 9.03 11.31 10.59 Fiscal Year End Dec 04 (Dec) 10.65 12.49 11.93 Shares 0/S (mn) 333 FY 39.88 46.31 43.66 54.50 52.18 64.09 62.14 Price Target ($) 1,015.00 Bloomberg EPS Pt (5) 39.72 46.10 53.33 83.07 Price Taroet End Date 31-Dec-14 Source: Company data. Bloomberg. J.P. Morgan estimates. See page 12 for analyst certification and important disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. wwwipmorganmarketssom EFTA01115312 Doug Mmuth North America Equity Research 19 July 2013 J.F!Morgan What We Liked: • Solid Google Sites growth. Google Sites net revenue of $8.2B (+16% Y/Y, +2.5% Q/Q) was in-line with our expectation and stable with 1Q13 growth levels. We expect the strong performance of Google Sites will continue, aided by strength in search and YouTube. We remain positive on YouTube's ability to soon attract more TV dollars and also note that YouTube mobile revenue in June was 3x that of the beginning of the year. Google search is also doing well, driven by mobile, farther expansion of the knowledge graph, and PLAs, with Enhanced Campaigns coming in the back half. • Progress with Enhanced Campaigns transition. Heading toward the July 22 deadline next week, advertisers have already transitioned 75% of active campaigns-6M—to Enhanced Campaigns. We believe that the combination of better targeting capability and cross-device analytics will ultimately drive higher ROI for advertisers and increased spend. • Solid paid clicks growth. Paid clicks growth of 23% Y/Y was higher than our forecast for 20.5%, though CPC decline of 4% was below our -3% estimate. We view solid paid clicks growth to be a good indicator of demand strength, driven by the continued shift to mobile. Google noted paid clicks and CPCs are impacted by a variety of factors including policy and product changes. platform mix, geographic mix, and channel mix. There are a lot of moving pieces here, but the higher volume offsets the lower pricing in our view and PLAs likely had some impact given their low CPCs and very high ROI. What Concerned Us: • Network Sites results softer than expected due to policy changes. Network Sites net revenue of $886M was 11% below our 5997M estimate largely driven by policy changes implemented in 4Q12 and 1Q13. Key initiatives include the AdWords policy change in October 2012 to reduce clicks on arbitrage pages and those with poor landing page quality along with the 1Q13 initiative that prohibits developers from directly opting in users to download toolbars and change their default search engine. We believe the impact here should be more stable in 2H13 and the changes should improve the user and advertiser experience over time. • Increased investments weigh on margins. Google Inc.'s overall profit shortfall was attributable to both Google Segment and Motorola. Google Segment non-GAAP operating margins also declined to 32.1% from 34.0% in IQ due to increased investments. Despite the pressure on margins in 2Q, we are incrementally positive on these investments into new products across Google services as we believe the company has been increasing its pace of innovation and focus on the user experience and there are significant market opportunities ahead. We expect core Google to return to leverage and expand margins modestly beyond 2013. • Softer than expected UK results. UK revenue of 51.32B (+12% Y/Y) came in below our $1.39B (+18% Y/Y) estimate due to a warmer spring/less time online, FX headwinds, and tougher Y/Y comps. Excluding FX and hedging impacts, revenue came in at $1348 (+15% VA'). 2 EFTA01115313 Doug Anmulh North America Equity Research 19 July 2013 J.F!Morgan Summary of the Quarter Google reported 2Q consolidated net revenue, EBITDA, and PF EPS of $11.09B, $4.94B, and $9.56, compared to our estimates of $11.41B, $5.26B, and $10.92, respectively. Figure 1: Google 2Q Performance vs. J.P. Morgan Estimates $ in millions. except per share data 2013 ($ in millions) JPME Actual. DM(%) Consolidated Gross Revenue 14,492 14,105 -2.7% Consolidated Net Revenue 11,411 11,092 -2.8% Google Gross Revenue 13,342 13,107 -1.8% Googie Web Sites' 8.915 8.868 -0.5% Google Network Sues' 3.347 3.193 -4.6% Other 1.080 1.046 -3.1% TAG' 3.081 3.013 -2.2% % or Total Gross Advertising Revs 23.1% 23.0% Google Net Revenue 10,261 10,094 -1.6% Google Web Sites 8,184 8.162 -0.3% Google Network Srtes 997 886 -11.2% Other 1.080 1.046 -3.1:4 Clicks WY 20.5% 23.0% PPC WY -3.3% 4.0% Google Operating Income 3,817 3,465 -9.264 Margin - Gross 29% 26% Google PF Operating Income 4,505 4,208 -6.6% Margin - Gross 34% 32% Motorola Revenue 1,150 998 -132% Operating Income (268) (342) Margin -23% -34% PF Operating Income (157) (218) Margin -14% -22% Consolidated EMMA 5.255 4.936 EBITDA Margin - Gross 36.3% 35.0% PF EPS 510.92 59.56 -12.5% GAP EPS 59.01 59.54 5.9% WY Growth Gross Revenue 18.6% 15.5% Net Revenue 18.7% 15.4% EBITDA 13.7% 6.8% Sequential Growth Gross Revenue 3.7% 1.0% Net Revenue 3.7% 0.8% EBITDA 5.8% -0.7% Source: Company reports and J.P. Morgan Sim tee. EFTA01115314 Doug Anmuth North America Equity Research 19 July 2013 J.RMorgan Adjusting Estimates Given Google's 2Q13 results modestly below expectations due to lower than expected Network Sites revenue, softer UK results, lower margins, and higher losses at Motorola, and we are adjusting ow estimates as follows: Figure 2: Adjusting J.P. Morgan Estimates - Consolidated Google Inc S in millions, except per share data Consolidsted Gavle Inc 3013 JPME 4013 JPME 2013 JPME 2014 JPME 2015 JAME (Sin tram Old New Old New Old New Old New Old New Google Inc. Gross Revenue 15.084 14.811 16.789 16.676 60.313 59.561 70.367 70.201 80.615 80.927 WV Mosta 70% 5.0% 75.4% 15.7% 17.4% 15.9% 184% 17.9% 14.6% 15.3% 092 Growth 4.1% 5.0% 71.3% 118% % sag vs. old 4.5% -03% -1.3% 42% 0.4% Google Inc. Net Revenue 11.828 11.629 13.169 13,147 47,414 48,878 55.279 56.548 83.043 84.012 Ylii Growth 4.4% 2.6% 75.1% 15.9% 17.3% 16.0% 18.6% 185% 14.0% 15.2V, CVO Growth 16% 4.8% 71.4% 111% % Ng vs. aid -I.7% 4.2% .1.1% 0.5% 7.5% EBITGA 5.484 5.265 5,989 5,857 21,877 21,028 25,879 24214 29,959 29.317 YIY Gasser 18.1% 13.8% 14.6% 121% 14.5% 11.1% 194% 19.9% 15.8% 16.3% Ma*, (%) - Grass 36.2% 35.5% 35.7% 35.1% 35.9% 35.3% 38.8% 35.9% 37.2% 362% % elv vs. aid -3.6% 1.2% .3.0% .26% -2.1% PF EPS $11.31 $10.59 $1249 $1193 248.31 $43.86 $54.50 152.18 384.09 382.14 WV Mose 25.3% 17.3% 17.3% 110% 161% 9.5% 17.7% 115% 17.6% 19.1% % c1, vs. old -6.4% -4.5% 5.7% -41% -10% Scarce: Lawny repots and J.P. Margin estralet 4 EFTA01115315 Doug Anmulh North America Equity Research 19 July 2013 J.FtMorgan Figure 3: Adjusting J.P. Morgan Estimates - Google Segments S in millions. except per share data Geese 3013 JPME 4013JPME 2013 JPME I 2014JPME 2015 JPME 55 in unions) Old New Old New Old New Old New Old New Germ), Gross Revenue Advertising 12.687 12.509 13.966 13.828 50.837 50.300 59.060 58.203 67.895 86.890 WVGrowth 15.8% 15.2% 15.8% 14.5% 16.4% 15.1% 16.2% 15.8% 15.0% 14.8% CO Growl', 3.5% 3.7% 10.2% 10.5% % cirg vs. old •1.4% -1.1% -1.1% -1.4% •1.5% Licensing d Other 1.199 1.232 1.393 1.530 0320 4.861 6.042 6.805 7.069 8.506 WY Growth 80.0% 85.0% eta% 85.0% 100.5% 1065% 28.0% 40.0% 17.0% 25.0% QM Grover 11.0% 17.856 16.2% 24.5% % dig vs. old 2.8% 10.1% 3.0% 12.6% 20.3% Total Gross Revenue 13.886 13,701 15,379 15.362 55.558 55.161 65.102 65.048 74.980 75.397 WY Growth 20.5% 192% 19.2% 190% 20.7% 19.8% 17.2% 17.9% 15.1% 15.9% CYO GroMb 4.1% 4.8% 10.8% 11.8% %ens vs. aid -1.0% 4.1% -0.7% -0.1% 0.6% Total TAG 3258 3.181 3.619 3.529 12.920 12.685 15,088 14.653 17.571 16.915 % of Gross Reams 25.7% 25.4% 25.9% 25.5% 25.4% 25.2% 25.5% 25.2% 25.9% 25.3% Y/Y Growth 17.6% 14.8% 17.5% 14.6% 17.9% 15.7% 15.8% 75.5% 18.5% 15.4% %siva,. old •2.4% -2.5% -1.8% -2.9% 37% Goo -Me Net Revenue Advertising 9.429 9328 10.387 10.299 37.917 37.615 43.972 43.590 50.323 49.975 WY Growth 16.6% 15.3% 15.2% 14.5% 15.9% 14.9% 16.0% 15.9% 14.4% 14.6% 0/0 Growth 2.7% 3.1% 99% 10.4% %tag vs. old -1.1% -0.7% -0.8% -0.9% -0.7% Licensing d Other 1.199 1232 1.393 1.534 0320 4.861 6.042 6.805 7,069 8,506 WY Growth 80.0% 85.0% aim 85.0% 100.5% 106.5% 28.0% 40.0% 17.0% 25.0% OM Growth 11.0% 17.8% 16.2% 24.5% %dig vs. old 2.8% 10.1% 3.0% 12.6% 20.3% Total Net Revenue 10.628 10.560 11.760 11.833 02,638 42.475 50.014 50.395 57.393 58.481 WY Growth 21.4% 20.6% 19.7% 20.4% 21.5% 21.1% 77.3% 166% 14.8% 16.0% 0/0 Grover 3.6% 4.6% 10.6% 12.1% %tag vs. old -0.6% 0.6% -0.4% 0.8% 1.9% Motorola Revenue 1.198 1.070 1,410 1,310 0.776 4,400 5265 5.153 5.651 5.531 Y/Y &oath -53.5% -S9.5% -8.9% -112% -10.5% -17.6% 10.2% 17.1% 7.3% 7.3% % dig vs. ord -10.7% 4.7% -7.9% -2.1% -2.1% GOOG Op Interne 3.879 3.736 4,245 4212 15.690 15.160 18.755 18.293 21.752 21404 % Margin - Gross 27.9% 27.2% 27.6% 27.4% 28.2% 27.5% 28.8% 28.1% 29.0% 28.4% % Mg vs. old -3.6% -0.8% -3.4% -2.5% -1.6% GOOG PF Op Income 4.613 0.077 5,057 5.041 18.577 18.129 22.156 21.770 25.655 25.381 % Margin • Gross 33.2% 32.6% 32.9% 32.8% 33.4% 32.9% 34.0% 33.5% 34.2% 33.7% % Mg vs. old -2.9% -0.3% -2.4% -1.7% .1.1% Motorola Op Income (201) (342) (163) (380) (903) (1.316) (569) (1.073) (388) 41.048) % Matraq -168% -32.0% -11.5% -27.4% -18.9% -29.9% -10.8% -20.8% -6.7% -190% % eng vs. old NM NM NM NM NM Motorola PF Op Income (107) (287) (52) (268) (495) (933) (376) (940) (165) (864) % Margin 4.9% -25.0% -3.7% -20.4% -10.4% -21.2% -7.1% -18.2% -3.3% -15.6% % dig vs. old NM NM NM NM 367.1% Scarce: J.P. Morgan esbmales. Care ay data. 5 EFTA01115316 Doug Mmuth North America Equity Research 19 July 2013 J.F!Morgan Investment Thesis, Valuation and Risks Google (Overweight; Price Target: $1,015.00) Investment Thesis Overall, we continue to believe Google fundamentals are strong. The Paid Clicks and CPC divergence is tightening, but more importantly we are projecting organic gross revenue to grow 20% in 2013. Core search growth remains solid and Google is now getting significant lift from display and mobile, which we forecast to combine for more than 30% of gross revenue in 2013. We are encouraged by the growth potential driven by mobile and display, Enhanced Campaigns, and PLAs. We also believe that Google will ultimately pare Motorola losses and potentially come out with Google- designed devices that are more competitive. Valuation Reiterating Overweight rating, lowering our PT from $1025 to $1015 on our lower estimates. Our December 2014 price target of $1,015 is based on —16x 2015E PF EPS of $62.14. We note that large tech peers on average trade at 1.2x PEG, a premium to Google's current PEG of 1.0x (based on our estimates). Additionally, we believe shares of Google should trade at a premium to the S&P500 PIE, which trades at —12.5x 2015 estimates, as Google is one of the few companies in the S&P 500 growing revenue and EPS both above a 2012-2015E CAGR of 16%, respectively. Risks to Rating and Price Target Downside risks include: I) potential for a return to heavy investment spending and margin compression; 2) continued competition for engineering talent; 3) Motorola integration risk; and 4) increased regulatory scrutiny. 6 EFTA01115317 DOLlg (211(11391 North America Equlty Research 19 July 2013 J.PMorgan Figure 4: Consolidated Google Inc Incarne Statement 3.4114 3.924 0.97.4 30171 39134 07124 036 171131 70136 rut 004411.4400 63100 4104441 3113144 114 lot , 11. 4- / , 131310 31060 04.1010 114.1101 04404 1104111 10401 $11.1111 tan< 40.41.01.99...% CAC, 40:60 115700 62701, 'IO 766 0 124420 310130 331813 53021 $12034 $14-633 3 34.9164 111•11bnensodwir6143 -12110.7.4 MIMA 10144 y I .:- . - : 7 ' - " 1424119 111.01111 1111121 14140.3 111.1423 $41,11731 176.34111 111241111 Onee (77.73173.3.0 $4.1110 1200 23140 -.. , -,., 100760 29420 2.9/40 300111 6510.1 12909.1 147201 169432 00141 00111 24914.9 4.00.4 2.11711 7.741.0 43774 14.1419 0.0220 1.117.0 11471 MW 32110 44.417.1 474401 Op-non •9399•49 board" 4.049,4werrI 49010 1.1420 1340 1.6110 Iµ13 54320 1.4760 14140 1900 1901.1 4404,3 1µY4 bµ99 Sain 4. 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